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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

 

Hi all,

We had a lousy September where we saw the S&P 500 fall 4.7% and the Nasdaq 100 fall 5.7% on the heels of worries about hyper-inflation, Chinese real estate developers defaulting on debt, rising interest rates, supply chain disruptions, and governmental dysfunction.  Well, October has been a new month, and with it will likely come new all time closing highs for the Dow Jones Industrials, Dow Jones Transports, the S&P 500, and the Nasdaq 100.  Most notable here is that NONE of the issues have been resolved, only pushed to the backburner of investor’s minds.

As we mentioned in our Q3 note to clients, “we expect most of these headwinds to resolve themselves in the next few weeks, which could set the stage for new all-time highs into year end.”  We’ll try not to break our arms patting ourselves on the back with this one.  The reasoning has been mostly due to the strong earnings being reported across almost all sectors of the economy.  According to Factset, as of October 22nd, of the companies who have reported, 84% have shown earnings above estimates, which is above the five-year average of 76% (and the third highest percentage of any quarter in the last 10 years).  All this tells us is that while there are headwinds to continued economic growth, corporations are extremely healthy.

For long time readers, you will know that when it comes to “timing” the markets, we prefer to use sentiment based analysis (fear and greed) rather than price based analysis (down 5% or 10% triggers).  We do this because every dip or correction or bear market or recession have similar emotional characteristics by which sentiment deteriorates to a point where fear starts to become the primary emotion.  Every cycle starts the same way; paralyzed by fear, but ends when we become blinded by greed.  While the negativity of the market has certainly gone by the wayside, and some signs of greed have started to creep back into investor’s minds (crypto, return expectations), we believe this run can be sustained into year-end (albeit very possible with another small dip first before a stronger rally into year-end).

Something to always remember is that the U.S. stock market is up 20% or more in 34 of the past 95 years (since before the Great Depression).  In that same time frame, it’s experienced a loss in 25 out of 95 years.  So historically, you have been more likely to experience a 20% gain than any yearly loss in the S&P 500.  This will be important to remember going forward as we continue to climb a wall of worry and the never before seen heights of the stock market continues to be tested.

So where do we go from here?  There are still a couple pockets of underappreciated sectors in there current markets where we feel there is still  opportunity to outperform and push markets to higher levels (biotech and emerging markets to name two).  Don’t get caught up trying to tell yourself “we need a pullback” or “this can’t last”.   The seduction of pessimism is always waiting in the back of intelligent investors’ minds, but having an optimistic outlook about the future is a major driver in achieving long-term competitive returns.

Sincerely,

Adam

P.S.  We read quite a bit of research and market commentary each month, but we found one this month that is definitely in our behavioral investing wheelhouse from Josh Brown of Ritholtz Wealth Management.  It’s called “The new Fear and Greed”.  Please give it a read HERE if you have a few minutes.  Understanding the ebb and flow of market emotion will serve investors better than an MBA ever could, in our opinion.

It’s getting near the end of the quarter and having traveled almost non-stop for the last couple weeks, I’m reminded of a quote by the American poet, Dorothy Parker, who said “I hate writing, I love having written.”  Ha.

While we’re still a couple months away from Turkey Day,  Brad and I find ourselves in a very thankful mood.  Since we weren’t able to see most of our out-of-town clients over the past 18 months, we recently embarked on a 1000 mile, seven-city trip through the Northeast U.S. and saw as many people as we could (our first of several before the end of the year, so if we didn’t end up seeing you, we will).  While our weight gain from the trip was extremely distressing, the overwhelming feelings we were left with were humility and happiness.  There is simply no substitute for human contact in order to strengthen a bond between people.  Seeing people in different parts of their lives (financial or otherwise) truly gives us so much joy, and even playing the smallest role in helping to achieve some life goals feels incredible.

We are just all truly lucky to have found each other, and I hope everyone feels the same way too.

– Adam

Hi all,

For our August missive, I thought I’d write a little about some of the things I’m hearing from YOU.  I have heard some variation of each of the following points from MULTIPLE clients over the last two months, so if you feel like you’re being singled out here, it couldn’t be further from the truth.  And in a counter-intuitive way (perhaps a second-level thinking sort of way?), it’s the reason I believe we continue higher in the equity markets into year-end.

“Stocks are at all-time highs, we should get a pullback pretty soon.”

Yes, the S&P 500 and Nasdaq 100 are currently at all-time highs.  While this is true, there’s more to the story.  The largest companies in the world have done a tremendous job holding up the indexes, but the pain being felt by investors in other individual names has been strong.  A quick search of Bloomberg shows the largest airline ETF has declined 26% from mid-March to mid-August.  Emerging markets are down 15% since mid-February, and the epicenter of the individual stock pain has been in the crackdown of Chinese tech companies, with the index seeing greater than a 50% decline in the last six months.  An index of recent IPOs is 17% off its highs and SPACs (special purpose acquisition companies), which were all the rage just several months ago, now 38% from its high.  Instead of a speculative bubble, it looks to me like the average investor is starting to figure out that fundamentals matter.  Last week’s all-time high in the Nasdaq was accompanied by the greatest number of new 52-week lows EVER (281).  Some see this as a sign of weakness under the hood and the possibility of a future decline as the strength of the rally narrows (possible).  I tend to view it as a market doing it’s job and being discerning.

“Inflation is going to be a problem.  Housing prices have gotten out of control.”

Let me show you a couple charts regarding housing.

At present the principal and interest as a % of income is the lowest in 50 years.  In other words, it’s more affordable to own a home, relative to your income than at any other time in the last half century.

And unlike the housing crisis which thrust us into the global financial crisis, this time, it’s the best credit scores looking to own homes.

Every day, week, and month there are issues that pop up, possibly causing the derailing of the current bull market.  While it’s our job to keep an eye on developing issues, I’d much rather be a student of price (what’s actually happening) instead of pontificating about future assumptions which may never come to fruition.  As of right now, the trend is our friend, but the trend may change, and we stand ready to make overall changes to our model if and when that occurs.  But for right now, trying to pick a top in the market is a fool’s errand.

– Adam

Verschlimmbesserung (German) is an effort to make things better, which really ends up making things worse.  No, I don’t know how to pronounce it.

For this month’s missive, we’re going to talk a little bit about what’s happening and not to be guided by what we’re hearing.

We’re hearing (especially in Missouri) about new mask mandates, the risk of the delta variant (although thankfully deaths and hospitalizations remain relatively low),  increasing tensions with China (I thought these trade wars were easy to win?), and rising inflation.

Here’s what’s happening.  The chart below of the Russell 2000 index (the de-facto proxy for the reopening of America) has gone sideways for the better part of six months after an amazing rally post-election (and post vaccine announcements).

While we have been outspoken “large-cap tech” buyers for the past several years, the spread between value and growth has now become stretched to a point where it would make some sense for technology to take a bit of a breather, while the underpinning of the American economy (small businesses) catches up a bit.

Just last week we saw an extreme in sentiment in relation to smaller businesses as shown by breadth (volume of stocks going up versus going down).  On Monday, July 19th, we saw just 15% of stocks contributing to “up volume” on the NYSE, but on Tuesday, we saw that ratio come back in spectacular fashion with 85% of volume on the NYSE on the upside.

According to Jason Goepfert of SentimenTrader, since 1962, the S&P 500 has never showed a loss in the month following similar signals. These mostly occurred during momentum markets, and buyers followed through to avoid missing out on the next bull run.  Our default expectation is that small cap companies will continue to rise as earnings season provides the proof in the pudding showing continued improvement.

So what does this mean for you?  While most of this has already been done for existing clients, quarterly re-balancing should probably focus on small cap allocations to lead over the next few months (or VTWO with a lower expense ratio, thanks Sandy).  Other than that, we still expect more bumps over the next few weeks, but our macro outlook for markets to be higher 6 months from now remains unchanged.

It’s still a relatively low volume part of the year (summer is always like this), so try not to get overly high or low based on short term movements.  One of my favorite quotes came from a recent Google conference call.  They said, “A management team distracted by a series of short term targets is as pointless as a dieter stepping on a scale every half hour.”  Your overall investment outlook should be the same.  Complexity is the language of the confused.  Let’s see what the market brings and try and not make this harder than it already is.

– Adam

This month’s missive comes from a blog post I read almost two years ago.  It’s from Movement Capital’s founder, Adam Collins.  It was just so simple and direct, I was immediately jealous.  With a seasonally strong period in the markets over the next 30 days (S&P 500 over the last 12 years has been positive 11 of 12 years, with a 3.3% average gain), it’s time to get a quick reminder of the basics, and remember things within our control (not the stock market returns) make all the difference.

– Adam

Sacrifice and Success

Sacrifice is necessary for success in life and investing.  Someone researching portfolio strategies or new hot stocks, but refusing to save more than 3% of the income is like spending hours at the gym and then driving over the Krispy Kreme for dinner.  You might feel good about doing something but you won’t actually make progress until you make a sacrifice.

Investors have to embrace the fact that they cannot predict the best portfolio for the future.  The silver lining is…that’s OK.  Recent studies have shown that 10 different strategies earned similar returns over the past four decades.  Most importantly, high fees transformed the best performing portfolio into the worst.  There are only a few things you can control that have a big impact on your finances.

• If you’re young, how much you save
• If you’re retired, how much you spend
• How you behave when markets panic
• Your allocation between stocks and bonds
• How much you pay in fees

Everything else is a rounding error.  The issue is we tend to focus on the rounding errors as it’s easy to get addicted to an endless rabbit hole of new investing ideas.  Announcing a new goal, not even achieving it, gives you a dopamine rush.  Investors get similar psychological payoff when they constantly buy and sell, even if the activity doesn’t add value.

The truth about investing in the current time period is that there isn’t an easy fix for high stock valuations and low bond yields.  No strategy can magically transform your portfolio into a low risk/high return future.  So what can you do?  Focus on what you can control and don’t get tempted by someone promising they can turn lead into gold.

As you may have heard, COVID cases, hospitalizations, and deaths are likely to reach pandemic lows over the weekend.  Recently, over 50% of the US population crossed the vaccination threshold and the optimism over a reopening economy is palpable.  In recent months, investment professionals throughout the country have rebalanced portfolios away from technology stocks toward these reopen names in the hopes of a “catch-up” trade, but our belief going into to summer would be to fade the move.  Howard Marks says this most simply, “Non-consensus views can make money for you, but to do so, they must be right.”  Something we do here at Second Level Capital, is to first help identify consensus.  This is difficult in it’s own right, but it’s where behavioral and sentiment analysis comes in quite handy.  Here’s a few examples over the last month.

According to Bank of America, two weeks ago showed the largest outflow from the tech sector since December of 2018.

Also from Bank of America, the technology allocation for investment professionals is now at the lowest point since the beginning of the global financial crisis in 2007.

 

Couldn’t get great quality on this one, but this one happens to be from Morgan Stanley which shows the divergence between the best performers of the market and the worst performers (emerging growth technology stocks, which were the darlings of 2020).

While we feel the reopen trade will continue and overall economic activity will reach levels not seen in many years, valuation is starting to become a concern for the reopen stocks and we believe a shift back TOWARD technology, specifically large cap technology, should be where new capital should be placed.

Overall, we expect more sideways action as the summer trading volume lull comes into focus.

For one more fun spurious correlation and a keen reminder that we do not have a crystal ball, is it possible that Phil Mickelson has done the market a favor by becoming the older ever Major golf tournament winner?

Have a great holiday weekend everyone!

Talk to you again next month,

Adam

As we sit here in late April, over the past week we have seen new all-time highs for the S&P 500, the Nasdaq, the Dow Jones Industrial Average, the Dow Jones Transportation Index, the Healthcare sector, the Consumer Discretionary sector….well, you get the idea.  Did you know that the S&P 500 has closed higher 14 of the last 15 years during the month of April for almost a 3% average gain? (a thank you to Steve Deppe for this one).  While April showers bring May flowers, it appears they also bring some decent stock market gains.

While the speed and magnitude of the sharp 10-year interest rate rise this year (from .91% to a high of 1.77%, now around 1.55%) had investors trading their fast growth and big technology names for more inflation-protected assets, we felt it was a dip worth buying.  We have continued to recommend large-cap technology throughout our portfolios, but not because we’re perma-bulls, but because history provides us context for a longer-term edge.  According to LPL Research, when coming from an all-time high price and dropping 10%, over 90% of the forward returns have been positive within 6 months (averaging 23% over that period too).

Furthering our confidence that it was a buyable dip was the fact that Nasdaq was in a seasonally weak period and tends to make its bottom in March.

Paraphrasing Michael Santoli, he said, “The choppiness of the past few months had been a fitful realignment of asset prices to account for a reflationary acceleration and profit recovery.  But along the way the “reopen trade” gets crowded and no longer cheap, while quality grows less loved and less expensive.”  Combined with the fact that the greatest percentage of global fund managers in the past 15 years believe that value will outperform growth, we simply felt that technology was a little unloved.

But as I mentioned at the beginning of the post, we’re back at all-time highs, almost across the board (the Russell 2000 small caps have lagged a big as the “reopening” stocks have taken a little breather.  So what now?  With over 95% of the S&P 500 stocks above their 200-day moving average, it doesn’t get much better than this.  Which is to say, that if you are devoting NEW capital to the markets, it’s probably time to wait for a better entry point, but our view that 2021 will be a positive one for overall equities is very much intact.  We are still watching our main possible pitfalls very closely (Inflation, Interest Rates, and COVID), but as the Federal Reserve had clearly indicated, it doesn’t see interest rates rising until well into 2022, and until then, market traders will likely continue to front-run any potential tapering of QE (which will be seen a precursor to an interest rate rise) as a sign of a top.  We are happy to let people continue to try and time the market and call a top, while we wait for actual information and then react as best we can.

Thank you all for reading, and look forward again to talking next month.

– Adam

 

 

 

This is a post we have hesitated to do for sometime, but given the many questions that have popped up over the last 2-3 years regarding speculative investments (electric vehicle component manufacturers, cryptocurrencies, NFTs, etc), we thought it would be nice to put down our official positions as something to look back on later.

As with most new things, people want to know one thing: “Why?”  People are fascinated with new investment ideas, specifically the potential to get in on the ground floor.  This inevitably leads to people doing their own research in a search for “why”?  Why is this happening?  Why don’t I own any?  Why does it keep going up?

My favorite retort to these questions was something I read from a former NYSE floor trader, Mike Epstein.  He said, “the search for ‘why’, whether right or wrong can just as easily lead you to irrelevancies, or worse yet, to valid data that will not impact the market.  The best analog is arguing with your wife.  Being right is often totally valueless if not counterproductive.”  In my opinion, the search for “why” is a fruitless endeavor, but I understand people’s need to search for meaning.

So let’s turn to bitcoin.  Bitcoin was born out of the global financial crisis.  Satoshi Nakamoto (his/her real identity is still unknown) wanted an alternative to the banking system.  The thesis was fairly simple.  Why do we need to use a bank for every simple transaction, increasing costs to use our own money?  When we go to the grocery store, why do I need to give them a card that debits my account and credits the store?  Can’t we just cut out the middle man?  While these initial ideas of dis-intermediation have sowed the seeds for the fastest growing and most cutting-edge technological firms of today (some of which we believe will have staying power), the reason we use a central banking system is simple.  Trust.  Both sides trust the bank to have the “official” record.

Satoshi figured out a solution to the old computer-science problem of building trust over an anonymous network.  The ensuing open-source technology created a system where access is unlimited, forcing everyone on the network to agree each time a transaction occurs.  As payment for making sure transactions are correct (proof of work), the “miners” are rewarded with a token (in this case bitcoin).  A collection of these verified transactions (chains) is then stored in a block, and once filled, a new block in the chain begins.  Guess what it’s called?  That’s right, blockchain.  I like to think of it as a worldwide shareable Google spreadsheet.  And that’s pretty much what it is.  A fantastic utility and a brilliant entrance into a potential new world.

From a technology standpoint, blockchain and the future innovations will be something we talk about for decades.  It has implications to disrupt almost every centralized business model in the world.  But from an investment standpoint, the blockchain is free.  From its inception, it was meant to be used by everyone and to decrease friction in the financial system.  So if there’s no way to profit from the blockchain (other than increasing the efficiency of current business models, hint hint), why has Bitcoin been the best performing asset of the last decade (by a WIDE margin)?

From an investment standpoint, Bitcoin feels like the “greater fool theory” on steroids.  Similar to gold, Bitcoin’s intrinsic value will always remain the same (1 BTC = 1 BTC).  Also similar to gold, it provides no cash flow, no balance sheet, no fundamentals whatsoever.  An asset based on pure emotion, albeit with amazing supply and demand constraints to help push prices higher. (forever?)

Please don’t get me wrong.  When a mania takes hold, price becomes irrelevant, at least for a while.  Seeing Bitcoin at a price of $100,000 or $1,000,000 or $0 are all very real possibilities, but as investment advisors, our main goal for clients is to avoid PERMANENT loss.  Ups and downs will be part of the risk you must be willing to take in order to receive the rewards, but as Warren Buffett famously said, “if you don’t feel comfortable owning something for 10 years, you shouldn’t own it for 10 minutes”.  This is the way we presently feel about most speculative assets in the current climate.  There’s just too much real of real loss to consider these vehicles anything other than sophisticated numbers on a roulette wheel.

But real financial advisors are guides in a changing landscape, NOT, defenders of an outdated map.  And just because something has worked before, doesn’t mean it will work later.  We only mention this as a way of telling you that the craziest of ideas deserve serious due diligence.  Risk should always be your primary focus and ours.  Something the equity markets are teaching quite clearly as it systematically clears excesses built over the past 12 months.  Until Bitcoin (and many other speculative investments) show their utility, it’s doubtful we will ever recommend an allocation to cryptocurrencies for a traditional, diversified investment portfolio.  It also doesn’t mean we’ll be right.  But for now, we plan to stick to the bird in the hand versus two in the blockchain.

– Adam

What else would we write about this month?  GameStop (NYSE: GME) and its ensuing short squeeze has been the culmination of so many factors over the past six months.  Fundamentally, it’s a quintessential casualty of our current digital transformation, a changing and difficult retail real estate landscape, and over the past month or so, “sticking it to the MAN”.

How could a company that was 1/1000th the size of Apple at the beginning of January send shock waves through the entire financial system?  Well, let’s see how we got here and perhaps give a bit of guidance as to where we might go next.

First, what is short selling?  When you purchase a stock, you have hopes that at some point down the road you can sell it for more.  Short selling is simply the opposite.  You sell shares first (which you’ve borrowed from someone else, but we will get to that later) with the hope you can buy them back at a lower price and thus keep the difference from where you initially sold (high) and bought back (low).  Seems odd to think that you’re allowed to sell a stock without actually owning it first, but that’s exactly what happens.

Second, why do you sell short? Shorting a stock usually occurs when you feel the fundamentals of a company are deteriorating and the value of that company will be much lower in the future than it is today.  In today’s market environment, the most heavily shorted companies are those hit hardest by COVID; victims of an increasingly digital society, like GameStop, AMC Theatres, Kodak, Blackberry, and Bed Bath & Beyond.  

Typically, short sellers are large institutions searching for excess returns for their clients (above index fund returns). Oftentimes, these firms will amass a large short position in a company and then publish negative “analysis” enlightening readers of the stock’s inevitable decline.  A practice that will likely come under well warranted scrutiny from regulators in the near future.

Finally, what happened? Institutional short sellers borrowed 140% of GameStop’s outstanding shares. Then, many traditional buyers entered the market (rallied together by the WallStreetBets crowd on Reddit) and bought shares of GameStop.  Because there were so few shares for sale in the market (remember all the shares have been “lent” to the short sellers) the buying pressure causes the price to jump quickly.  Short sellers then scramble to “cover” by buying their shares back.  This, in turn, increases the buying pressure, causing the price to rise even further.  These are the conditions for the prototypical short squeeze.  

What’s the takeaway? The practice of allowing institutions to use excessive amounts of debt (shorting in itself is quite healthy and a great source of stabilization in declining market) will, no doubt, be the subject of future congressional hearings and further regulation on the financial markets.  Anytime the internal plumbing of the financial markets is threatened, new laws are passed to attempt to shore up cracks in the pipes.  In 2008, it was Dodd-Frank.  In 2000, it was Sarbanes-Oxley.  In 1987 it was the invention of circuit breakers, and even going back almost 100 years, in 1929 it was the SEC itself.  

Given the number of political agendas that have hijacked this market quirk, I very much doubt this time will be any different.  In our experience, during market dislocations, there are very few individual investors that make money and to be honest, most lose it (sometimes with very sad consequences, like this).  We understand why people feel the urge to play in this space, but without any long-term underpinning (fundamentals), these are pure gambles and should be avoided.   The number of incredible businesses borne out of COVID should be more than enough to scratch the itch of great investors, if they are willing to buy and hold.

Overlooked during the market frenzy has been some of the best corporate earnings in the history of the stock market.  Apple made more than $100B in a quarter for the first time ever.  In 2020, Walmart had revenue of $16,614….per second.  Amazon grew revenues 44% year-over-year for their 77th consecutive quarter of double digit revenue growth.  The fundamentals on main street appear stronger than ever and with optimism regarding reopening and stimulus, combined with some light at the end of the tunnel, it doesn’t seem so far-fetched to see the market continuing to run.  Why shouldn’t it with these types of numbers?

Here’s the rub.  “The market is currently caught in a stand-off between strong momentum & and excessive sentiment & speculative fever.” (h/t David Steets).  Combine that with my favorite Charles Bukowski quote and we get to where we are today.  He said, “the problem with the world is that the intelligent people are full of doubt, while the stupid people are full of confidence.”

Our overall view of the market remains solidly bullish for 2021, and while we anticipate MAJOR pockets of turbulence, we believe looking back and staying with current equity allocations makes the most sense…for now.

– Adam