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Hi all,

In last month’s post, we mentioned struggling with the idea of whether or not to follow our conviction of rotating from technology to cyclicals (large companies to smaller ones).  We decided to wait for additional signs of the market rotation before making any substantive changes.  It was a good move.  With a week left to go, the Nasdaq 100 is up another 4.5% this month, extending a rally that has gone further than almost any analyst had predicted at the start of the year (why do we listen to these meteorologists?).  So we’re in the same spot today as we were a month ago:  Knowing that a pullback/decline is coming, but waiting until we see the turn before rebalancing portfolios since we believe this rally may have a little more juice left in it.

Without much change to our overall view, here’s a few research pieces of note from this month.

1. The S&P 500 is up around 10% for the year.  In the past 70 years, when the S&P is up 10% or more at the end of June, the final six months are up, on average, 82% of the time, with an average return of 7.7%.  A good first half usually means a good second half.

2. The market has broadened out somewhat this month, but it’s still top heavy.  This isn’t uncommon for the stock market, but it’s something to watch.  Ideally we would want to see the “unloved” names participate in the rally to make us feel more comfortable (energy, real estate, small caps).  Unfortunately, the market doesn’t care about our comfort level.

3.  Adding to our feeling that the market may still have a little higher to go is the percentage of advisors that are still underweight equities (nervous and sitting in 5% treasuries).  If the market were to continue to drift higher, it’s very possible that clients become fearful of missing out on the next bull market run (FOMO) and decide to jump back into the market on any pullback, large or small.

Summer has officially arrived in St. Louis with temperatures nearing 100 degrees this week.  Hopefully, everyone is staying cool and as always, we’re here if you need anything.

– Adam

Hi All,

I’m phoning it in this month as I was all ready to write a post about the rotation we believe may be occurring before our eyes (small caps playing catch up to large caps), but I’m just not quite convinced that this means large caps will go down.  So rather than being precisely wrong, we’ve decided to try and be generally right and wait it out a bit.

Below is a tweet thread from Jim O’Shaughnessy.  Jim is founder of O’Shaughnessy Asset Management, and a pioneer in quantitative investing (computer driven modeling).  Now that computerized trading has become ubiquitous, he’s one of a large crowd, but most important to me are his opinions on the behavioral side of investing.  His views most clearly mirror mine, and it’s a bit long-winded, but it’s important to realize how our emotions will always remain our greatest weakness and our greatest source of opportunity.

Happy reading everyone, and congrats to all the graduates out there!

– Adam

Markets change minute-by-minute. Human nature barely changes millennium-by-millennium. There’s your edge.

How To Arbitrage Human Nature: A thread

People want to believe the present is different than the past. Markets are now computerized, high-frequency and block traders dominate, the individual investor is gone and, in his/her place, sit a plethora of huge mutual funds and hedge funds to which he has given his money. Many have simply given up trying to earn alpha in the market and have given their money to index funds. Some people think these masters of money make decisions differently and believe that looking at how a strategy performed in the 1950′s or 1960′s offers little insight into how it will perform in the future. But while we humans passionately believe that our own current circumstances are somehow unique, not much has really changed since the unarguably brilliant Isaac Newton lost a fortune in the South Sea Trading Company bubble of 1720. Newton lamented that he could “calculate the motions of heavenly bodies but not the madness of men.” Herein lays the key to why basing investment decisions on long-term results is vital: the price of a stock is still determined by people.

If you chart price of the South Sea company’s stratospheric rise and then compare it with the NASDAQ in the 1990′s, you’ll see they are virtually identical. As long as people let fear, greed, hope and ignorance cloud their judgment, they will continue to misprice stocks and provide opportunities to those who rigorously use simple, time-tested strategies to pick stocks. Unless you believe that human nature will fundamentally change soon, using long-term studies of which stocks do well and which do poorly lets you arbitrage human nature. Newton lost his money because he let himself get caught up in the hoopla of the moment and invested in a colorful story rather than the dull facts. Names change. Industries change. Styles come in and out of fashion, but the underlying characteristics that identify a good or bad investment remain the same.

Each era has its own group of stocks that people flock to, usually those with the most intoxicating story. Investors of the twenties sent the Dow Jones Industrial Average up 497% between 1921 and 1929, buying into the “new era” industries such as radio and movie companies. In 1928 alone, gullible investors sent Radio Corporation from $85 to $420 per share, all based on the hope that this new marvel would revolutionize the world. In that same year, speculators sent Warner Brothers Corporation up 962 percent—from $13 to $138—based on their excitement about talking pictures and a new Al Jolson contract. The 1950s saw a similar fascination in new technologies, with Texas Instruments soaring from $16 to $194 between 1957 and 1959, with other companies like Haloid-Xerox, Fairchild Camera, Polaroid and IBM being beneficiaries of the speculative fever. Closer to home, remember all the dot.coms of the late 1990s that soared on little more than a PowerPoint presentation and a lot of sizzle? And, of course, now we have Bitcoin…

The point is simple. Far from being an anomaly, the euphoria of the late 20’s; 60’s and 90’s were predictable ends to a long bull markets, where the silliest investment strategies often do extraordinarily well, only to go on to crash and burn. A long view of returns is essential because only the fullness of time uncovers basic relationships that short-term gyrations conceal. It also lets us analyze how the market responds to a large number of events, such as inflation, stock market crashes, stagflation, recessions, wars and new discoveries. From the past the future flows. History never repeats exactly, but the same types of events continue to occur. Investors who had taken this essential message to heart in the last speculative bubble were the ones least hurt in the aftermath. They understand that today’s events and news are mostly noise, and that only longer periods of time deliver the much more accurate signal. As Pericles said, they “wait for the wisest of all counselors, time.”

The same is true after devastating bear markets. Investors behave as irrationally after protracted bear markets as they do after market manias, leaving the equity markets in droves, usually at or near the market’s bottom. By the time they gather enough courage to venture back into equities, a good portion of the recovery has often already happened. Investors who remained on the sidelines in 2009 left between 50 and 75 percent of gains on the table, making it very difficult for them to catch up with the market. We are always trying to second guess the market, but the facts are clear—Our emotions and biases are toxic to good long-term performance and we *must* get them under control so that rather than letting them control us, we take advantage of them and arbitrage human nature, the last sustainable edge.

Hi All,

Frequently, I get feedback from clients about our monthly blog posts, and most of the constructive criticism surrounds me talking less.  Point taken.  For this month, let’s show a few more visuals.

As you know, the majority of our market timing calls are about buying when people are scared/nervous, and trimming when investors are euphoric (or more precisely, when they start to discard the possibility of future problems).

1.  This chart comes from the most recent Bank of America Global Fund Manager Survey.  As you can see, cash remains the highest overweight, while US stocks have been the vehicle by which they have chosen to raise that cash.

2.  For an idea of how much cash in “sitting on the sidelines”, we again turn to Bank of America’s global research department.  We now have more cash sitting in money markets than we did at the height of the pandemic.

3.  Why has all that cash flocked to money markets and US treasuries?  Because the federal reserve has raised interests rates at the fastest pace in US history. For years, there was no reasonable alternative to equities, but that time has passed.  With investment grade corporate bonds yielding over 5.5% and short term treasuries yielding north of 5%, there are now some very compelling choices.

4. The relative calming and grinding upward nature of the stock market, tends to mean sunnier skies are ahead.  When the first quarter of year doesn’t go below the lowest price in December, the return for the final three quarters of the year has been higher 33 out of 36 times since 1950 (with an average return of an additional 11%).

5. According to the most recent survey from J.P. Morgan, 95% of respondents believe the S&P has already peaked for 2023.

As a reminder, strongly bearish sentiment DOES NOT mean that stocks will go up from here, but it absolutely tilts the weight of the evidence in favor of stocks going higher.  That’s the best we ever get in the stock market.  There are a couple market signals that are holding us back from being more aggressive in client accounts, but if/when those signals turn from red to green, we will be ready.

– Adam

Hi all,

In case you’re not laser-focused on the happenings in the financial world, let’s catch you up to speed.  The second and third largest bank failures in history occurred this month with the receivership of Silicon Valley Bank (SVB) and Signature Bank (SBNY).  Confidence in the financial system has been shaken, but the Treasury department, the FDIC, and the Federal Reserve are attempting to reassure markets and stem the tide.  Their quick and decisive action to backstop uninsured depositors (over the 250K FDIC limit) was the right thing to do…for now.  The entirety of the unintended consequences can’t be known at this time, but there will be a price to pay down the road.  We’ll save that for another blog post.

So what happened?  Can it happen at my bank?

Firstly, no bank can withstand a massive run.  If everyone in the country shows up at Bank of America tomorrow and asks for their cash, it’s gonna be a problem.  It’s the reason that the faith and confidence in the banking system is so crucial.  So why did SVB fail?  A healthy dose of stupidity, with a dash of quirkiness.  Banks have an odd accounting rule that allows them to not mark down a bond if they intend to hold it to maturity. This effectively hides huge unrealized losses when interest rates rapidly move higher (bond prices and interest rates are inversely related).  When a bank has a problem and has to liquidate some of those bonds in order to meet demands for outflows, they sell what they can, not what they want.  At SVB, the percentage of their deposits above the FDIC limit was approximately 94%.  At Bank of America, it’s 46%.  At Charles Schwab, it’s 20%.  But what happens is that you end up with a deposit base that grew from $60B in 2019 to $190B in 2021 (mostly from the recent tech craze) and SVB ended up buying long term bonds paying 1.5%.  Flash forward two years and eight rate hikes later, you’re left with massive unrealized losses and a highly concentrated deposit base (startups and tech firms) running businesses which are bleeding cash.  In one week, $48B of deposits left the firm, causing them to sell their bonds at fire sale prices, realizing losses in excess of the entire value of the company.  Right now, it feels as though the problem is idiosyncratic, and somewhat of a fence is being put around select regional banks, but it’s not that simple.  ALL banks are sitting on massive unrealized losses because interest rates have risen so quickly.  The system needs time for these bonds to mature (years) and massage balance sheets to reflect the current interest rate environment.

That brings us to what this means for the overall economy and what it means for your money.  If you have a cash balance above the FDIC insurance limit with one financial institution, please fix this.  It’s $250,000 per account type, meaning you can have $250K in an account for you and 250K in an account for your spouse, making the total insurance coverage $500K.  Another alternative would be to transfer money into your brokerage account to purchase a money market mutual fund or short-term treasury bills (hopefully you aren’t getting tired of us asking you to do this as we’ve been doing so for the better part of the last 12 months).

Most interest rate hiking cycles end when something breaks.  The problem right now is that the FED is stuck between a rock and hard place.  They massively raised interest rates to fight inflation (a real danger), but in doing so, caused financial system instability.  The million dollar question is whether or not the FED will pause their interest rate hikes to let the “long and variable lags” of monetary policy work their way through the system, or do they believe this was a “one-off” problem that can be dismissed and continue on their path to tackle inflation. Time will tell.

As the saying goes, “When the tide goes out, only then do you realize who isn’t wearing a bathing suit”.  Is it a few bad actors, or a sign of things to come?  It all depends on how much longer the FED wants to lean on the economy to get inflation under control.  This week there is potential for another rate hike, and unlike any meeting in recent memory, there is massive uncertainty about what they are going to do.  Some analysts think they should continue on their path.  Some believe they should pause or even CUT rates with recent bank failures as proof they’ve gone too far.  My honest guess is that the FED will try to have its cake and eat it too.  They will raise another .25% next week, but the commentary surrounding the rate hike will be a clearer timeline of when they intend to pause.  This should give the market a little more clarity, which it desperately wants.

Either way, we’ll be watching.

– Adam

 

Hi all,

In our last post, we spoke about our view that a new bull market had started.  Since the close on January 12th, the Nasdaq 100 rose 12.4%, while the S&P 500 rose 5.3% and the Russell 2000 (small caps) was up 7.23% at their peaks, respectively.

We also attempted to stress that this does not mean there won’t be pullbacks and we don’t think that we’re headed for all-time highs in 2023.  In fact, in the first three months following a breakaway momentum signal, the average decline in percentage terms is 5.6%.  And while it’s always possible the market falls further and we take out the October lows, it would be unprecedented.  On February 15th, the S&P 500 closed above its 200-day moving average for almost 4 straight weeks.  No prior bear market in history has made a new low after making 18 consecutive daily closes above its 200-day average. None.  If you’re betting on the market continuing lower from here, you’re implicitly saying “it’s different this time” (we don’t do that).

Combined with seasonal trends (see chart below courtesy of BTIG’s Jonathan Krinsky), a pause not only seems fitting after a stellar start to 2023, but also welcomed so that stocks can continue to make a base at this new price level and sow the seeds for the next advance.

Even though we are looking for a bit of a pullback into mid-March, we believe historical trends remain on our side.  It’s a bit of cherry-picking the data, but a negative year for stocks, followed by a January that is up more than 5% has happened five additional times since 1950 (2023 was the sixth occurrence).  In those five other time periods, at year-end the S&P 500 was higher in all five, with an average full-year return of close to 30% (see chart below courtesy of Ryan Detrick from Carson Investment Research).

Learning to get more comfortable with the ups and downs of the market is a huge step in being able to weather the storm.  After a great January, and a good start to February (not so much recently), try to zoom out and look at the bigger picture.

– Adam

Hi All,

We’ve been purposefully waiting a bit to post this month’s missive in the hopes there was something big brewing in the markets.  Well, it turns out we’ve seen the first constructive, actionable, bullish signals in the past 24 months.

In January of 2022, we wrote,

“Over the past few years, our position has been some variation of “the trend is your friend”, but in 2022, we feel this is likely to change.”

While we thought 2022 wouldn’t be anything to write home about, the velocity and magnitude of federal reserve interest rate rises certainly caught us off guard in Q1.  The idea they would hike interest rates at the fastest pace in history was not something on our radar and our underperformance versus the overall market was a direct result.

But in April, we began to stress the need for patience, foreseeing a bear market rally that would eventually fade, leading to some additional pain.

“The possibility for another sharp advance could be in the cards, but our current view is that more frustration is ahead.”

In August, we rebalanced our more conservative and moderate portfolios, taking advantage of the summer rally by transitioning from municipal and corporate bonds into short-term treasuries, as well as lightening up growth equity exposure, as our tone and actions remained cautious, awaiting additional signals.

In our October blog post entitled, Where’s The Bottom, we wrote,

“Rather than picking a bottom (which is pure luck, even if we were to do it), here’s the conditions that need to occur for a bottom to be cemented.”

I won’t rehash the blog for the entire last year (although I do recommend going back and rereading, if you’re interested), but my point in highlighting some of the past commentary is that we believe the time for more aggressive positioning is upon us.

So what’s changed?  Underneath the surface of the market, a lot.

First, we achieved a “breakaway momentum” signal.  Below are the forward returns.  This is a signal that has only happened 24 times since 1949.  23 out of 24 times, the market has been positive a year later, and on average, 20% higher.

Second, is a different measure of breadth, but just as powerful of a signal.  This one is called a Whaley Breadth Thrust.  January 12th of this year marked the 20th occurrence since 1970.  The previous 19 were all positive one year later, with an average rise of 21.8%.

What does this mean?  To me, it means the wind has changed directions.  Instead of being in a market environment where we take one step forward and two steps back (bear market), we are now entering a paradigm of two steps forward and one step back (bull market).  We believe the odds of allocating capital in this environment have switched decidedly in our favor.

Let me also stress what this doesn’t mean.  It does not mean that the S&P 500 will go up every day until we make a new all-time high.  It does not mean that there will not be periods of time where the market drops (sometimes substantially) and our confidence will again be shaken.  But having the anchor of history on our side does provide the confidence to start allocating more capital to sectors we saw exhibit relatively strength during the last half of 2022 (biotech, small cap) as well as sectors that remain in strong fundamental positions and prioritize returning capital to shareholders in the form of dividends or buybacks (energy, financials).

While risk remains our primary focus, we’re as optimistic about the upcoming year as we have been in more than half a decade.  If you’re willing to continue to place your trust in us, and come along for the ride, we believe the next 12 months will be full of surprises (good ones this time).

– Adam

As we enter the “Santa Claus Rally” phase during the final five trading days of the year (as well as the first two of the following year), let’s look back on the trends of 2022, and think about what may come in 2023.

As you can see from the chart below, courtesy of Liz Ann Sonders, chief investment strategist at Charles Schwab, there have been very few places to hide.  After more than a decade of growth stocks trouncing value names, the unloved equities ended up with the last laugh, although December has been a month to forget among months to forget this year.

The S&P 500 is on pace for the 4th worst year since the modern inception of the index in 1957.  Back-to-back down years have only happened during four distinct periods: The Great Depression, WWII, Stagflation of 1973-1974, and the Dot Com Bust.  Maybe we’re in one of these periods, it’s certainly possible, but not my base case.

Bears have outnumbered Bulls in the AAII sentiment poll for 39 consecutive weeks (since April 7).  That’s the longest streak since they started tracking the data in 1987.  The University of Michigan’s Consumer Sentiment Index has been below 60 for 8 consecutive months, the longest streak since they started collecting data in 1952.

Why do I even care that everyone is so bearish?  Why do I even follow these statistics?  Because, in general, the markets vacillate between “the sky is falling” and “irrational exuberance” (guess which one is it right now).  But in the real world, things usually stay somewhere between “pretty good” or “not so great”.  The chart below shows what happens when the market decides (some day) the sky ISN’T falling, and realizes, once again, this too shall pass.

This past week, Guggenheim’s chief investment officer, Scott Minerd, had a massive heart attack during his routine morning workout and died at the age of 63.  Late last year, Citi’s beloved strategist, Tobias Levkovich, was struck by car and passed away at the age of 60.  The last three years have brought more death and sickness than most of us have experienced in our lifetimes.  During this holiday season, while we preach to have a longer-term outlook on your financial life, please remember how relatively short our time here can be.

We will be sending out our 2023 outlook early in the new year, so be on the lookout, but until then…

Happy Holidays and Merry New Year to all!

– Adam

Thought I would switch it up this month and take a little time away from the markets (they will be there next week, don’t worry) to give some perspective to our overall lives.  For this month’s missive, I’m going to pick out a few pieces from Bob Seawright’s latest post.  Bob is a financial writer, but almost always with interesting tidbits about the intersection between life and wealth.  His newsletter, The Better Letter, is read by thousands, and I can’t encourage people enough to sign up here.

Contrary to doomscrolling on Twitter, or even the nightly news, by almost any measure, just about everything today is amazing.

Yet no one seems happy.

The things that matter in terms of happiness are those you would expect: a good marriage, a loving family, personal autonomy, and being charitable.  As we sit around our Thanksgiving tables, please take a couple minutes, hug a few seconds longer, and just realize how astronomically lucky we all are.

– Adam

P.S. – Personal shoutout to my father whose birthday was yesterday, and a fun picture of us from the newspaper 30 years ago (!!).  Happy Birthday, Dad.

 

 

It’s the number one question on everyone’s mind.

“Where’s the bottom?!?”

I don’t know.  I also know that no one else knows.  So assuming NO ONE on the planet can predict where we might go next (although I’m certain some of you are SURE the market is going lower), let’s examine for a minute, what a major market bottom looks like.

Like many, I believe the S&P 500 will be higher, 12 months from now.  I believe this for many reasons.  They are outlined in several previous posts about negative sentiment, oversold conditions, historical numbers looking 12 months out from a large number of stocks making their 52-week lows, etc.  But rather than picking a bottom (which is pure luck, even if we were to do it), here’s the conditions that need to occur for a bottom to be cemented.  This is a bit more technical than some other posts, so if you’re my wife, you can stop reading here.

Since 1945, there have been 24 instances of a term Walter Deemer coined in the 1970s called “Breakaway Momentum” (also now known as a “breadth thrust”).  This occurs when ten-day total advances on the New York Stock Exchange (NYSE) is greater than 1.97 times the ten-day total NYSE declines.  It usually comes in three parts.  The first is the initial strong bounce off of major lows, which usually occurs during several days (we’ve seen a few of these “one-week wonders” recently, each one a hallmark of a bear market).  Secondly, during the middle part of the 10-day stretch, the market needs to HOLD its ground.  The real trick to achieving breakaway momentum is not to keep going up substantially everyday, but to keep the declines limited during the inevitable ups and downs that occur in any ten-day period.  Lastly, during days 7-10, the market again has a major bullish move (William O’Neil coined the term “follow through day”) to give the final signal that stocks have bottomed.

When we get into bear markets, investors lose their anchor (and their nerve).  There is no way whatsoever to know how low, nor for how long, the S&P 500 will go between now and that 12-month end point.  Maybe not much at all, but maybe a whole lot.

There will be re-balancing opportunities, and if you have cash on the sidelines, I urge you to remain patient.  When the signal is separated from the noise, you can bet we will be here to make sure we capitalize as much as we can from the ensuing rebound.

– Adam

Hi all,

As first alluded to in our post from April of this year,  patience remains paramount.  The massive accommodation to the economy from years of ZIRP (zero-interest rate policy) combined with the unprecedented fiscal stimulus during the pandemic created the “helicopter money” scenario made famous by Ben Bernanke during the great financial crisis of 2008.  For the better part of the last 15 years, we heard that gloom, boom, and doom, were headed for the United States as we would eventually have to face the music for leaving monetary policy so lax and for ignoring the past lessons of hyper-inflation from the Wiemar Republic and countless other examples throughout world history.

This year, we have begun to pay the piper.  The effective Federal Funds Rate, the rate at which banks borrow from the Federal Reserve (and which affects all other consumer rates), is now 3% after the Fed meeting last week.  The purpose of this is to combat inflation as well as mop up the excess liquidity in the system and get back to a monetary policy in which the Federal Reserve is neither helping (accommodative) nor hurting (restrictive).  The pace and magnitude of these Federal Reserve moves, at least for the last 50 years, has been the fastest on record.

From the beginning of this year, we have seen a systematic flow of funds out of highly speculative assets such as cryptocurrencies, non-profitable tech stocks, pandemic darlings, and “meme” stocks, to name a few.  We believe the next excess to be eliminated will be quick stock market returns.  There is a collection of individuals in the stock market still looking to cut corners.  We believe in order for the stock market to gain solid footing and start to be priced based on fundamentals, we will need to see the weekly option volumes collapse, and the gamble (YOLO) mentality to fade.  In recent weeks, betting against the economy (and the stock market) has gained as much fervor in the opposite direction as we saw during the post-pandemic euphoria.  Here’s a couple charts to show how historically negative people have become.

To show the point a bit differently, if you were to eliminate each week of the month where options expire (typically the third Saturday of each month), the S&P 500 is almost unchanged for the year.

Investors have even gone so far as to sell a greater percentage of equities during the past few months than they did at the depths of the great financial crisis.

What does all this mean?  For younger investors, or those of us who are still adding to our long-term portfolios, it’s actually good news.  If you make the assumption that the world isn’t going into the next great depression, these purchases at lower prices will end up being some of the most difficult ones to make, while at the same time, being some of the most profitable of your financial journey.  For those of you approaching retirement, we made a substantive change near the beginning of August, rotating out of bond funds, into shorter duration treasuries to ensure that the stable portion of your portfolio acts as a buffer.  And finally for those people taking income from their portfolios, it’s an opportunity to trade up in quality once again (just like in March 2020) to ensure stable dividend yields to help fund retirement expenses.

And just because I choose to be a bit of a glass half full type of advisor (this is more profitable over the long-run, trust me), there is a morsel of good data that we may be reaching a bit of an inflection point and a bear market rally may be in the cards, albeit after the early part of October.  In the past 10 years, when the amount of downside protection for individual stocks has outpaced upside bets on any given day, the average return over the next two months is 11.82% (but the bad part is that over the next two weeks, the average downside is -7%).

Hold your nose a bit longer and we believe your patience and resolve will be rewarded.

– Adam