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Hi all,

While we’ve had a nice bounce this month (as was expected), the outlook remains as clear as mud.  Here’s a couple things to think about on each side of the ledger.

Valuations

At the June low, there was almost 12% of all companies trading on the NYSE trading at a market value below the amount of cash they had on their balance sheet.  This means that the stock market valued their respective businesses at $0.  As you can see from the chart above, these types of moves have signaled major bear market bottoms in the past.

Small and Mid-cap company valuations are now well below the long-term average and currently below where we were in March of 2020, although not yet back to 2008 levels.

Defensive Posturing

According to the Bank of America Global Fund Manager survey, cash levels are now the highest (as a percentage of assets) since 2001.  “Cash on the sidelines” it seems.

Workers

According to ZipRecruiter, there are now 1.8 million more full-time workers than before the pandemic and 2.4 million fewer part-time workers.  When the government turns off the taps and interest rates rise, you can almost hear the collective refrain of “I need to get a better job” echoing in everyone’s head.

Historical Trends

According to Jason Goepfert of Bespoke, the S&P 500 has never lost ground over the following 12 months when we’ve had advancing volume of greater than 87% for 2 out of 3 days in the first month coming off a 52-week low.  The median returns after this signal is 23% over the next year.

We feel the stock market is inadequately prepared for something to go RIGHT (for once in 2022).  This asymmetric risk/reward points to getting more upside out of good news, and less downside out of bad news (since everyone has already positioned themselves for the worst).  Because of this, we feel the issue going forward won’t be where we go, but when.  Given the Federal Reserve, at present, does not have any intention of providing accommodation to the economy (lowering rates), and a main goal of the administration is to combat inflation (lowering demand), it’s going to be very difficult for the market to gain its footing with its two largest market forces acting against it.  The thing to remember here is that the stock market is NOT the economy.  The stock market looks forward, while economic data looks backward.  It’s one of the main reasons we’ve seen the stock market increase in July.  Gasoline prices at the pump have come down over 10%, crude oil pricing is off almost 30% from its highs in March and those declines should start to come through in the inflation data starting this month or next.  The stock market is starting to sniff out that things are getting a little better, but will the market rise enough to entice that cash on the sidelines to start nibbling again?  We shall see…

Enjoy the last bit of summer and be safe out there.

– Adam

 

Hi All,

After our last post on May 26th, the markets finished their best week of the year with the S&P 500 and Russell 2000 rising 6.5% and the Nasdaq 100 up a little over 7%.

But since then, the S&P 500 has fallen into an “official” bear market.  Per Jason Goepfort of Bespoke Investment Group, it proved to be the first time the S&P ever failed so quickly after a 7% relief rally.  To be honest, regardless of whether or not the S&P 500 went down 19.8% or 20.1% means little difference to professional market watchers.  We ARE in a bear market, and in our view, it’s been a bear market for a little over a year (regardless of the major indexes holding up through most of 2021).  According to Bank of America, over the past 140 years, there have been 19 bear markets with average price declines of -37%, but more importantly the average duration of these bear markets (through the accepted definition) has been 289 days.  As far as seasonal trends are concerned, per the Stock Trader’s Almanac, Q2 and Q3 in midterm election years have been historically weak (although not as much in the last 10 years or so).

What does it all mean?  Should we expect a bounce, and use that as an opportunity to lighten up on stocks before they head back down again?  Will we see “traditional” capitulation?

The great financial writer for the WSJ, Jason Zweig, tells us that there are three ways to get paid to write:

• • Lie to people who want to be lied to, and you’ll get rich.
  • Tell the truth to those who want the truth, and you’ll make a living.
  • Tell the truth to those who want to be lied to, and you’ll go broke.

The truth here is that we don’t know.  Our best guess at the moment is that we are in for another substantial decline later in the year (a retest of the recent lows) to coincide with the seasonal trends, probably around 3400-3500 on the S&P 500 (essentially back to Feb 2020 levels).  I would peg my conviction of this view as 70% retest and 30% we start to base around these levels and make our way back toward all-time highs (I know, I know, blasphemy).

The case being made for us moving higher from here, but not going back down is gaining traction, but there are a couple main pieces to the argument:

• • Sentiment is still at historic lows.  But as of right now, sentiment has been as historically low levels for months, with very little movement back to the upside (and very little to be optimistic about).
  • According to the Bank of America Global Fund Manager Survey, the cash balances in customer accounts have risen to a level greater than April of 2020, the highest figure in the last 20 years.  This is potential fuel for the next advance as naysayers become believers when prices go higher, which is the exact opposite of how you should view investing.  The stock market is the only place I can think of where people get scared when stocks go on sale.
  • Most importantly are the historical comparables to what happens when the S&P 500 drops 15% or more in a quarter (this would only be the 9th time in history).  As you can see from the chart below.  The next quarter is up 6% on average, and is 15% higher on average over the remaining half of the year.

I think we tend to move a little higher from here and then we see how the market reacts.  While past performance is not indicative of future performance, past behavior is.  This is why during every cycle, the names and fears change, but humans don’t.  Buying into fear and selling into greed will stand the test of time.  The hard part is figuring out when the market is fearful enough and when it turns back to greed.

– Adam

Brad and I thought it was a good time to send out a note of ours from 2020.  We’ve updated some of the numbers, and a little of the verbiage, but the playbook is still the same.  And the reason it’s the same is because human fear and greed are the only constants over differing market cycles.  We’re all running the same software inside our heads.

This time IS different.  They are ALL different.  That’s how short-term thinking invades our long-term strategy and waves the proverbial carrot, making us think we can avoid the pain and only take part in the good times.  If you find a way, please let us know.

Over the past 13 years, the S&P 500 is up about 500% (it’s closer to 600% if you include dividends).  As impressive as the bull market has been, the relatively muted volatility, to me, has been the most impressive part.  The reason it’s been so amazing was outlined succinctly by Tony Dwyer, Chief Market Strategist at Canaccord Genuity.  He wrote that “in the real world, things generally fluctuate between ‘pretty good’ and ‘not so hot.’  But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless’.  What I can say is that four months ago, most people thought the macro outlook was uniformly favorable, and they had trouble thinking of a possible negative catalyst with a serious likelihood of materializing.  And now the unimaginable catalyst is here and terrifying.”

Embracing the unknown and realizing that we won’t be able to pick the bottom is the first step, but regardless of the size of the decline, our playbook remains the same:

1. 1. Extreme downside inevitably leads to a reflexive reaction to the upside due to market fear leading all investors to being on the same side of the boat.  Given the vast amounts of negative news, there is an asymmetric risk/reward for good news, although we don’t know in what form this will take.  In February 2016, it was something as simple as a vote of confidence from the CEO of one of the largest banks in the world, Jamie Dimon (known in the financial world as the Dimon bottom).  In November of 2008, it was Warren Buffett making a large investment in Bank of America to give America the confidence to do the same (even though the market didn’t bottom until March of 2009).  What will it be this year?  We will only know in retrospect.
   2. The reflexive rally will likely only go high enough to burn off the fearful/oversold condition, not to repair the entire damage.  Per our blog post on March 9th, 2020, we continue to expect a reflexive rally to lessen the fear in the marketplace.  We anticipate this rally to be in the magnitude of 10%-15%.  For reference, a 10% rally will take us back to around 4400 on the S&P 500.  The idea that this will be a “V-shaped recovery”, similar to Q4 2018 and March 2020 is unlikely in our opinion.  During that period of time, the market was reacting to one specific issue, interest rates.  Once Federal Reserve chair Jay Powell did a 180 degree about face in December of 2018, the market did the same.  The current crisis will be filled with uncertainty for some time.  When will we start to see inflation peak, and inevitably subside?  When will Americans have the confidence to freely move about the country and the rest of the world?  How will these events affect the numbers of corporate America, and in turn, the economy overall?  Will the paradigm lead to a further transformation for corporations and lead to greater opportunities (telemedicine, cloud-based workstations, e-commerce options)?  These are questions we will not have clarity on for some time.
   3. In order to be reactive, we rebalance and/or add to equities if you’re able to do so, as the market retests the oversold low.  Our process here at Second Level Capital is a systematic one, exactly for times like these.  There will be a time and place to reassess everyone’s emotional capacity, but now is not the time to panic or change your strategy.  If you started the year at a 70/30 (stock to bond) allocation,  your account is down somewhere between 15%-20%.  When we go to rebalance your account in the coming days/weeks, the process dictates taking cash (or bonds) and buying more equities to get your portfolio positioned to take advantage when times are better.  Having a system in place that takes the emotion out of this decision is the only way anyone would ever do it.  If I took a poll of clients right now who are chomping at the bit to put more money in stocks, I don’t think I’d get too many takers, although it has proven over time to be the prudent action.

The pain over the past four months has been unprecedented by many different metrics.  But I’ll leave you with a quote attributed to Morgan Housel (one of the greatest financial writers of our time), who said,

“There are only 3 edges in the market:

• • You can be smarter than everyone else
  • You can be luckier than everyone else
  • You can be more patient than everyone else

What’s your edge right here, right now?”

We’re here to chat with anyone who needs a confident voice because we’ve been here before, and came out stronger on the other end.  I believe we will again.

– Adam

Hi all,

After a horrible start to 2022, the S&P 500 managed to rally 11.4% from March 14th to March 29th.  Just enough to save a little anxiety when people opened their 401K statements in early April.  Since then, we’ve retraced most of that move, but have oscillated between 4200 and 4500 on the S&P for the last few weeks.  Every bit of optimistic news seems to be immediately met with additional Federal Reserve hawkishness (raising rates faster to combat inflation) or disappointing economic news.

We view the rally in mid March as more of a technical one.  Meaning simply, that too many people became too bearish, too fast, and an inevitable snap back was on the horizon.  Flash forward to now, sentiment again has reached massively negative levels, and in fact, we have some of the most negative readings since the early 1990s, even lower than during the global financial crisis (see below, courtesy of Bespoke).

The good news about the negativity permeating the markets is that when the AAII bullish percentage goes below 20%, it usually doesn’t stay there for long, and three months later, there is a 93% winning percentage over the last 35 years, with the one outlier in 2008.

So the possibility for another sharp advance could be in the cards, but our current view is that more frustration is ahead.  Wanting to get back to the high watermark in your investment accounts will not make it so.  As we have said in previous posts, patience is paramount.  Below is a another chart from Ryan Detrick of LPL, showing that especially in midterm election years, the markets don’t usually bottom until later in the year, with the average being around August 14th.  The good news here is that 12 months later, we have been positive 100% of the time since 1950, with an average (from that bottom) of 32%.

The early read from corporate earnings is that they are holding up quite well, but we continue to believe that something will need to break in the favor of the bulls on the fundamental side for the advance to really catch its footing.  The urge here feels like we need to “do something”, move faster, or make up for lost time.  In our experience this is precisely what gets people in trouble and that’s what we will likely continue to internally fight over the next few months.

What we’re watching right now is for any signs of inflation peaking (CPI/PPI reports cooling off a bit, energy and commodity pricing coming down), interest rate declines (the 10-year rate under 2.64% could signal a short-term trend change), or some type of resolution for the Russian/Ukraine situation (which is a much larger problem for Europe, but is still affecting American pocketbooks).

We hope that everyone had a nice holiday and after the next few weeks of earnings as well as the Federal Reserve rate decision in mid-May, we should have a little more clarity about where we are headed.

– Adam

This month we’re going to take a step away from the markets and just talk a bit about us at Second Level Capital.

Relax.  There’s nothing you’re missing in terms of short-term or long-term strategy that has any statistical edge to it, so if you’re thinking of making any changes based on exogenous market factors (Ukraine, inflation, interest rates, etc.), the only real answer I have for you right now, is to sit back and wait for clarity.  There will always be the option to flip a coin and choose correctly, but that’s not investing, it’s coin flipping.  The rally we’ve seen off the lows, at the moment, has an equal chance of being a “bear market rally” or possibly the start of something more interesting to the upside.  Time will tell.

As for Brad and I, things are moving along nicely.  Notwithstanding a pretty snowy February, and our bouts of COVID-19 that swept through each of our families, we can’t really complain.  Children are getting older (we’re not) and new market environments bring new challenges, but that’s to be expected.

Our assets under management grew by about 35% last year, bolstered both by onboarding new clients as well as some outsized market performance.  We remain in “growth mode” at least for the next several years, so please speak kindly about us when you’re lamenting your Q1 portfolio performance with friends.

As some of you may or may not know, there are a decent amount of clients that Brad and I both have not met personally.  As we live in an increasingly digital world, offering financial advice through Zoom or over the phone, certainly doesn’t feel as strange as it used to.  But our job as advisor is more than being an investment allocator, it’s also being a bit of a money therapist.  It’s to find out what makes people tick, and then using that knowledge to build a plan that can bend, but not break.  Our job shouldn’t be one that’s all smiles and rainbows when you’re a new client and then you get sloughed off to the support staff when times get tough.  Today’s environment is a fantastic example, and generally when times get tougher, we tend to gain more new referrals and clients.

So as soon as it was reasonably feasible (both travel-wise and health-wise), we sought out to see as many clients in person as we could.  Share a meal.  Share the idiosyncrasies in thought and manner which provide a different perspective as well as the vulnerability needed to have a real relationship.  Believe it or not, this is THE deciding factor in our decision whether or not to accept a new client.  Would we want to introduce our families to you?  Would we want to share our own imperfections and emotional struggles?  It’s been amazing to see how our “strategy” has compounded into a community of people we respect immensely.

All of this is to say, that if we haven’t come to see you, we will.  We take very seriously the trust you’ve placed in us, and for those of you who have been with us from the beginning when Second Level Capital was simply an idea, we owe you everything, and we won’t forget it.

– Adam

After a January that saw the S&P 500 decline by more than 5%, February is nearing a close with similar results.  At this point, it would be very natural for the “snowball effect” to start occurring in your minds.

As always, taking a measured approach, rather than emotional one will continue to be our advice.  That being said, let’s take a look at several different possibilities moving forward.

1. 1.  A New Normal

With the market now expecting 5+ rate hikes in 2022 (effectively doubling the 10-year Treasury yield from last year), are we now in an environment where it’s impossible for stocks to go up?  Well, looking back at the market since 1950, that hasn’t quite been the case (tip of the cap to Ben Carlson from Ritholtz Wealth Management for doing the heavy lifting here).

2.  The Perfect Storm

Adding to the Federal Reserve’s tough talk about raising interest rates to tamp down inflation is the geopolitical environment.  Below is the list of every major geopolitical event of the last 75 years and how stocks fared during the event itself and then how long it took to recover.  Seems like a lot of green for something that feels like the end of the world, doesn’t it?

3. Same as it Ever Was?

Our contention at Second Level Capital is that everything that’s happened this year as it relates to the indexes has been pretty normal.  Here’s a list of stock market returns since 1928 and how far the S&P 500 fell from it’s – high.

The only real problem we see is that the two LEAST volatile years in the last 25, have been 2017 and 2021.  Said another way…you guys are spoiled.  The average drawdown over this 94 year period is -16.5% (the S&P 500 was down 12% this year, which lasted for about three hours on January 24th).

Paraphasing CNBC’s Michael Santoli, the million dollar question is if the ability for the S&P 500 to hold this current level (down about 10%) with 5+ rate hikes on the horizon, oil nearing $100 per barrel, and large tech firms like Facebook losing hundreds of billion dollars in market cap is an impressive show of resilience, or a delusional delay of the inevitable.  The answer will come in time, but our bias remains the former.

– Adam

 

 

Hi all,

2021 was a stellar year in the financial markets with the S&P 500 up almost 30% (including dividends).

The strategy of not overthinking the pandemic-related changes proved fruitful, and while we saw some glimpses of the potential start of the “great rotation” (growth to value), the largest companies became even larger.  Apple, Microsoft, and Google (with their combined value of more than $7 trillion), saw their stocks rise 30%, 50%, and 60%, respectively.

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.  Here are some risk factors that will determine where equity markets end 2022.

Politics and the Economy –  Our first chart comes from Ryan Detrick at LPL Financial.  As you can see, mid-term election years tend to see the largest volatility of any year in the election cycle.  We feel this year will be no different.  Expect wider ranges and deeper pullbacks.

As of right now, the way-too-early mid-term election polls are mixed, but certainly not terribly positive for the Dems.  Higher odds for a divided congress and further governmental gridlock are on the rise.  Divided houses of congress are generally a positive for equity markets (no news is good news).

According to the WSJ, small businesses are more worried about inflation than they have been in the last 40 years.

On the flip side, while price inflation is in focus, the greatest number of small businesses raising the wages for their workers is also the highest in over 40 years.

Federal Reserve – We can’t tell everyone “don’t fight the FED” for the last 13 years, and when they change course, still put out reasons why the market is bullish.  In our opinion, that makes you a permabull, not an impartial advisor.  That being said, our job as advisors is to find a way to make money in any market environment, and while rising interest rates will tamp down economic activity (and subsequently inflation as well), the timing of when the market hits the proverbial skids is a little different than you might think.  Over the past 40 years, looking 12 months out after the first interest rate hike, the market is higher 8 out of 8 times.  We believe 2022 will make it 9 out of 9.

Overall we’re expecting a year of fits and starts, one that will likely annoy almost all participants.  Timing luck will be an important part of overall return, so while the indexes are down 5% or 10% from their highs, we see these are buying opportunities, but with the caveat that there is a likelihood we still go lower in the short-term.

We are forecasting a single digit increase (3-7%) in the S&P 500 for 2022, as any excess gains beyond the trend of the last 30 years (around 10% per year) will likely be seen as a green light for Fed officials to continue to tighten monetary conditions.  As market participants realize this, traders will start capturing small gains quickly instead of holding larger positions for longer (the optimal strategy in trending markets).

We believe money will likely start to seriously flow to those countries and sectors where monetary policy is likely to remain easy, even while the US moves to combat inflation.  It’s said that when the US gets a cough, the rest of the world gets a cold.  The USA is the only country on the planet that is now in a better economic place than it was pre-COVID.  We think the rest of the world will need additional time and medicine (accommodative monetary and fiscal policy) and we expect money to flow to Europe, China, etc.  A geographically diverse portfolio, while a drag on performance in previous years, could be the piece that outperforms in a transition 2022.

– Adam

 

Hi all,

In our previous note, we wrote. “As of now, our outlook is for a pullback into late November and possibly into early-December and then a potential resumption of the rally into year-end.  For those with cash on the sidelines, we recommend waiting for a better entry, and we are currently contemplating making additional substantial changes to our models for almost all clients going into next year, but we will reach out individually if/when we decide on what changes need to be made.”

Since the date of the previous post (Nov 19th), we have seen a peak to trough decline in the S&P 500 of 5%, a 7.3% decline in the Nasdaq 100, and a 9.7% decline in the most economically sensitive stocks of the Russell 2000.  As of right now our opinion has not changed, but it does have some caveats.

• • We believe that the omicron variant will continue to show that while it is much more transmissible, it is likely to be less deadly and lead to less hospitalizations than the delta variant (the traditional life cycle of viruses, and very similar to what happened during the Spanish Flu in the early 1900s).  We believe this will avoid broad lockdown measures in the United States, which should bolster travel-related stocks, as well as more economically sensitive sectors (energy, cruise lines, casinos, etc).
  • The breadth issue we discussed in the previous post has resolved itself.  When we see “panic selling” (as defined as greater than 90% volume to the downside on the NYSE) as we did last week, generally we need either back-to-back 80% positive days, or one 90% positive volume day on the NYSE to signal that buyers have started to come back to the market.  This condition was acheived Monday and Tuesday of this week, which has lead to the bounce we’ve seen this week.

For some more data on sentiment, according to Bloomberg, traders sold out of the most-traded stocks at the fastest pace in the last two decades, even faster than the global financial crisis in 2008-2009.

Not surprising, long dated government Treasury bonds had the opposite happen, seeing the largest inflow in almost a year.  We believe this flight to safety was warranted, but with the Federal Reserve signaling a possible acceleration of tapering their quantitative easing and potentially interest rates RISING in 2021, I think this flight to safety will be short lived, and investors will head back to the only game in town…stocks.

Our reasons for “buying this dip” are not just technical as well.  Per the Bureau of Economic Analysis, profit margins over the last two quarters for U.S. businesses are the highest since 1950.

In addition, historically (according to Factset), December has the highest likelihood of having a positive month, moving up 74.3% of the time since 1950.

We believe we will see a retest of the recent lows, but anticipate that buyers will come in again and setup the traditional Santa Claus rally (the trading days following Christmas before year-end).

Happy Holidays everyone!

– Adam

Hi all,

Since the end of Q3, the stock market overall has been on a tear.   Small caps are up almost 6%, the S&P 500 is up almost 8%, and the technology-heavy Nasdaq 100 is up greater than 12% in the last 50 calendar days.  The market continues to follow the traditionally bullish seasonal period from November to January, although the signs of weakness underlying this market could be a reason for pause in the short-term.

Our first roadblock is breadth.  Breadth is a measure of how many stocks are advancing vs. how many stocks are declining.  Obviously in a very healthy market, we would love for more advancers than decliners.  For most of the month of October, the NYSE had substantially positive breadth meaning that the bulk of stocks in the NYSE universe were moving higher.  Since the turn of the month, while indexes continued to make new highs, breadth began to roll over.  Leadership has narrowed, and since the S&P 500 is a market cap-weighted index (the larger companies push and pull the indexes more than the little guys), the renewed strength of Apple, Amazon, Google, Tesla, etc., have masked some of the weakness under the hood.  On November 18th, the Nasdaq saw the most number of stocks making new 52-week lows since March of 2020 (surprising given the all-time highs in the overall indexes).  This typically resolves itself in one of two ways.  Either the gravitational pull from the vast number of individual stocks begins to weigh on the larger names as well (entire market starts to pullback), or the individual stocks gain some strength into year-end and lead us for one more push toward higher highs on the S&P 500.

Other possible roadblocks are the re-emergence of COVID-related issues around the world (preventing supply chains from returning to normal), inflation-related concerns weighing on the overall consumer (although household debt as a percentage of assets remains at all-time lows), interest rate fears, and potential valuation issues with the S&P 500 now reaching a P/E multiple of around 25 times near year’s earnings.

While we continue to believe that valuation pressures and inflation concerns are overblown, they should not be dismissed outright.  As of now, our outlook is for a pullback into late November and possibly into early-December and then a potential resumption of the rally into year-end.  For those with cash on the sidelines, we recommend waiting for a better entry, and we are currently contemplating making additional substantial changes to our models for almost all clients going into next year, but we will reach out individually if/when we decide on what changes need to be made.

Happy Thanksgiving everyone!

– Adam