Client Letter June 23, 2020

Dear Client

I wanted to take a moment here to explain why we have so much cash uninvested at the moment.

The rise in the Nasdaq index is masking significant weakness in the S&P 500 index and the Russell 2000. The strongest Nasdaq names have gone parabolic – meaning they will likely revert downward just like a rubber band snapping back to form.

In addition, the Nasdaq is very extended and 16% above its 200 day moving average (dma) which was the same divergence at the February peak. There’s no rule that says it has to turn down at this point. The 2000 Nasdaq peak was 35% above its 200 day moving average. But a +16% divergence means the risk right now is terrible.

Eventually the Nasdaq and its 200 dma will meet again. Either by a choppy sideways trend or more likely a broad sell o.

Vegan Humane Investing

In addition healthy bull market rallies will show an increasing number of stocks making New Highs for the year. Despite the Nasdaq being higher now than in February, there are far less stocks making new highs. This is not healthy at all.

The lack of a broad base rally without all stocks in the various Indices participating creates a vulnerable market prone to failure.

It’s not just the Nasdaq showing poor participation. The S&P 500 is showing its form of poor participation. A healthy rally from the March bottom would be showing at least 50% of stocks above the 200 dma. Right now its just 42%.

Vegan Humane Investing

If markets cool in the heat of the Summer I’d consider that a significant plus. I have no idea if the Nasdaq is putting in a long term top or not. A sell-o to its 200 dma could be an attractive entry point for Growth stocks.

In the meantime Banks (excluding Wells Fargo) and Value stocks, while extremely attractive, are languishing. The divergence between Growth and Value is remains the greatest since 1999. But it’s been impossible to predict a turn from Growth to Value. Whenever it does occur, the returns will likely be outsized.

Gold, which broke out of its trading range to the upside this week, would be vulnerable in any significant market weakness. When investors need to raise capital they’ll sell anything.

Summary: Expect significant market weakness soon. Many headwinds are likely ahead which are in the news on a daily basis. Last week’s 1800 point decline saw the Fed start the printing press again to prop up stocks once again. Regardless, markets need to revert lower for “the pause that refreshes”. Hence the risk right now is very high.

Be safe, Brad Pappas

Vegan Humane Investing

“Markets are never wrong, only opinions are” Jesse Livermore

“Markets are never wrong, only opinions are”
Jesse Livermore

January 27, 2020

Jesse Livermore was amongst the first great stock traders of the early 20th Century. One of his basic concepts is that we trade markets and individual holdings. An investor should have little concern for opinions and anything else that can distract from following price. If this current market proves one thing it’s: Markets and economies are two different things and don’t necessarily have to correlate.

If you think this means I’m not going to lay out my thoughts to you of what I think may happen, you’ll be right! All of my best performance years occurred when I kept my blinders on and didn’t listen to anyone. Instead I reacted to market signals and price changes when they occurred rather than trying to anticipate the future.

Last October the stock market proved that I was wrong with my belief that we were in the mire of a long term market topping process. This opinion was backed up by a substantial amount of weak economic data that under normal conditions should have led the US into a recession this year.

Keep in mind the data is still pretty bad but it has been offset by $60 billion per month and almost $400 billion in aggregate in Treasury assets (The Fed buys the Treasury security and pays the seller with cash, who in turn can buy stocks).

In my opinion there is an unholy alliance between the Fed, Mnuchin and the President to keep the stock market rallying into the election as if it were a matter of national security.

Markets and many stocks have gone “Parabolic”. I use the term Parabolic on occasion when necessary. One of my most important rules is: Parabolic moves in stocks, markets or any other asset are unsustainable and burn out quickly but the timing of peak price is unknown.

Assume its impossible to accurately predict when the parabolic bubble bursts – my intent is to play this move for all its worth and be prepared to exit fast. The decline from a parabolic move is usually quite deep. I would be looking for a decline of 15% to 20% sometime this year.

Tactically I’ve taken a middle of the road approach by using tight stop loss orders. So as a stock like Virgin Galactic or Beyond Meat may leap higher, my stop loss prices move accordingly just under the stock price.

Current portfolios have a solid group of core growth stocks that comprise the majority of our holdings. Stocks with multi-year uptrends and reliable earnings growth make this list. Holdings considered “core” include: Fair Isaac, Copart, Mastercard and Visa, Global Payments and Adobe, Cable One, etc. Since I’m not expecting a long term bear market, these stocks can be held and hedged should the market turn down.

Approximately 20% in aggregate of our allocation is devoted to the fast and furious movers like Beyond Meat, Virgin Galactic, Sea Ltd and Audiocodes, etc. These have already made large moves and will be sold quickly should they show signs of declining with the market selloff.

It used to be that market timing via Federal Reserve policies was difficult but still possible. But that’s a thing of the past as we are in the midst of the greatest amount of central bank cash infusion since the Great Recession 10 years ago. World central banks are trying to avoid a recession by swamping credit markets with cash. In doing so, much of the cash goes into the stock market as banks and funds lever up and push the markets higher regardless of the lack of earnings growth and a slowing economy.

January 27th, 2020: Seemingly out of nowhere at least three issues have emerged which are causing the stock market to roll over.

1. The rise of Bernie Sanders is polling. As you’re probably well aware, Bernie has moved ahead of Biden in many states. His popularity creates a stark economic contrast to what presently passes for economic policy. Investment markets are discounting entities – in other words, markets will begin to move one way or another till November depending on which candidate is the perceived winner. DJT’s policies are positive for stocks in the short term while Bernie Sanders presents a severe headwind for the future.

In anticipation of a Democratic winning in November, I would anticipate higher capital gains taxes in the future – this is one of the prime reasons for the core Growth stocks mentioned earlier. It is my hope they can be held in excess of a year to qualify for the long term capital gains rate.

If your account is in a non-taxable IRA or Rollover, these core holdings will still be a benefit long term – unless the Fed pivots from ultra easy policy to inflation-motivated tightening.

2. The Coronavirus: Aside from the obvious potential lethality and its effect on travel, trade and healthcare, the virus represents another hurdle for supply chains. Last year I wrote about how important supply chains are for manufacturing productivity. They have been significantly disrupted by the unending Trade wars. Now, the Coronavirus present another issue compounding the issue. Will this final straw to move US manufacturing out of China to someplace local?

3. The Fed has begun to reduce its capital flows. I’m willing to bet they’re thinking twice about that choice now. The rise in stock prices in the 4th Q of 2019 was not due to any economic rebound. It was due to the Fed adding massive liquidity (cash) to the banking system. Last week they started to ease off.

As I mentioned earlier, this government does now want to see natural price discovery for the stock markets as that would give the Democrats and edge. So I wouldn’t be surprised to see the Fed go back to their $60 billion goal should stocks get hit hard.

Sell Signal: My proprietary models are beginning to show that it’s time to sell a portion of stocks and use the cash balance for hedges. My goal is to minimize net losses for what may lay ahead. Considering the magnitude of the move higher since October this isn’t surprising but I would like to protect as much of our January gains as possible. At that point we can allow the selloff to evolve with some peace of mind.

Brad Pappas
January 27, 2020

Value Stocks Risk/Reward

Value Stocks Risk/Reward

November 12, 2019

An issue I haven’t mentioned this year has been the profound weakness in Growth stocks since August. Most of the hot running high momentum stocks from earlier this year have been taken to the woodshed.

One of the reasons for money migrating out of high growth stocks is that the valuations became extreme relative to Value stocks. If there is once concept that investors in every asset class must understand is Mean Reversion. Prices always revert back to their long term trends. Think of the Tech Stock bust in 2000. The money from the sale of the overvalued Tech stocks went into Value stocks.

When I refer to “Value” stocks what I’m referring to are stocks that are cheap or have a low value relative to the underlying company. These are companies that are slow growth growing only single digits percentages a year. They can be boring businesses that don’t have a lot of sizzle to their story unless you’re a numbers geek like I am.

Right now the Risk/Reward is heavily skewed to Value stocks. The Value universe of stocks include a hefty percentage of banks and insurance companies. These financial companies saw their valuations compressed due to very low interest rates and the Inverted Yield Curve.

As you can see the Value stock methodology had dominated performance until the Great Recession of 2008. The lack of performance from Value does coincide with an uptick in activity or manipulation by the Federal Reserve.

What can’t be denied is that interest rates have moved higher which can increase profit margins and loan growth for banks and insurance companies.

Brad Pappas
November 12, 2019

July 2018 Client Letter

“Nothing but blue skies ahead”

National Trade Council Director Peter Navarro
– June 25th, 2018

July 1, 2018

Summary: Last month I wrote about the Fed and what I expected could happen by the end of 2018 or early next year. My timing last month was too optimistic as things are coming to a head now. I expect the 3rd quarter to be volatile with a downward bias as the Fed and the European Central Banks (ECB) continue to destroy their economies and markets with policy errors.

The world’s stock markets are in the process of crashing. It’s naive to think that the ripple effect will not happen here. Unless the Fed states that they’re going to pause raising interest rates or halting QT (see below), we can expect a market sell-off in the 15% range. This may be one of the reasons Trump tweeted that he asked the Saudis to increase oil production. There isn’t much inflation in the system right now except for energy prices. By increasing production with the hope of lowering the price of oil, it may be enough reason to for the Fed to halt rate hikes. But we really don’t know what the Fed will do at this point.

At the start of last week, we had three big issues to contend with.

1) The rapid rise of the U.S. Dollar (USD) versus the Chinese Yuan.

China does manipulate their currency against the U.S. as detailed in the chart below. Spikes in the USD/Yuan valuation in recent years have been catalysts for dramatic sell-offs in U.S. stocks. Part of the problem is, in a world starved for short term yield, money is now being converting to USD to buy short term yields. In addition, the effect of QT (See below #3) is also a cause for the increase in demand for USD to buy Treasuries. Regardless of the reason, the devaluation of Chinese Yuan negates much of the tariff risk to China while also having a negative effect on the U.S. economy as U.S. goods become more expensive. Add tariffs to the mix and you can expect a significant slowdown in U.S. growth soon.

UUP-CYB, Socially Responsible Investing

The rise of the USD – caused by the Fed raising short term interest rates and investors liquidating short and intermediate term bonds – is causing Emerging Markets (EEM) to crash. The break below the EEM’s primary moving averages occurred at the same time the Fed most recently raised interest rates.

EEM, Socially Responsible Investing

I had been watching the EEM exchange traded fund (ETF) along with its inverse ETF which rises as the EEM declines. We were able to make initial purchases in the $41-$43 zone. See below. I am using the EEV as a hedge against our current stock holdings.

EEV, Socially Responsible Investing

This is how the world’s regional markets are reacting to Fed and ECB policies:

EIDO, Socially Responsible Investing

 

ILF, Socially Responsible Investing

 

FXI, Socially Responsible Investing

 

EEMA, Socially Responsible Investing

 

VGK, Socially Responsible Investing

All of these international charts are in the Bear Market zone.

2) The Yield Curve

The Yield Curve continues to decline and, unless the Fed stops raising short term interest rates, it should cross below the 0 threshold which will signal an incoming recession. For more on this click on the following link.

https://www.federalreserve.gov/econres/notes/feds-notes/predicting-recession-probabilities-using-the-slope-of-the-yield-curve-20180301.htm

UST, Socially Responsible Investing

In the chart above, the closer the Yield Curve gets to zero, the more nervous investors will become.

The studies show the recession could be as long as a year or two following an inverted yield curve. But stocks move in anticipation of the future, and the Financial and Industrial stocks in the U.S. are moving into Bear Markets. We don’t need another banking crisis but that exactly what the banks are showing. Just brilliant timing by Congress to eliminate many of the restrictions after the 2008 debacle.

The industrials have to contend with both trade wars and the Fed raising rates. They’re signaling that our present GDP growth is coming to a hard stop unless the Fed stops their behavior.

XLI, Socially Responsible Investing

High Yield Bonds – otherwise known as Junk bonds – can act like an early warning signal as they are a reflection of the risk in credit markets. If Junk bonds are selling off and Treasury bonds are rallying, that tells us there is trouble brewing as money exits risky credit for safe credit.

HYG, Socially Responsible Investing

High Yield is on the verge of signaling that credit markets could be become increasingly concerned about risk.

3) Quantitative Tightening (QT)

Lastly we have QT. QT is the inverse of QE known as Quantitative Easing. After the collapse in 2008, the Fed and the ECB went on a series of actions (QE) whereby the Fed bought huge amounts of Treasury bonds in an effort to lower interest rates making stocks, treasuries, real estate etc… more attractive. In doing so, they created huge wealth for those who owned risk- oriented assets. However, the downside is that the Fed now owns a huge inventory of bonds and other securities and they have mandated that they must now begin selling off their inventory to “reduce their balance sheet”.

The liquidation on the open market by the Fed and the ECB is known as QT or Quantitative Tightening. When a central bank sells a security on the open market, the buyer is giving cash to the Fed in exchange for the security. On a mass scale, this reduces the amount of cash or USD in the system.

The primary driving force in the stock market is the ebb and flow of cash in our economy, otherwise known as liquidity. When cash is coming into the system, it makes its way into the markets and drives prices higher. The inverse is also true but we’ve never actually experienced QT before. It could be a disaster on its own. But combined with rising short term interest rates, it could be lethal to the buy-and-hold long term investor.

I’ve shown many charts that show the deterioration of the markets in the U.S. and abroad. In June, the Fed was selling off $30 billion in inventory a month and look at how much damage that created.

Come this month (July), the Fed and the ECB will both be enacting QT. The Fed is scheduled to raise the amount of liquidation from $30 billion a month to $50 billion.

Summarizing

I believe the Fed’s attempt to normalize interest rates is failing. My guess is that, at some point, the Fed will stop but the question is how much further damage will be done before they signal a white flag.

In the past two weeks, I’ve reduced our clients’ risk exposure greatly by adding inverse exchanged traded funds and adding Treasury bonds. Treasury bond prices should rally quite nicely if the Fed continues on its course of action as money moves to safety.

Should there be further weakness in the S&P 500, I’d like to add inverse ETF’s based on the SP 500 as well. A break below 2670 would potentially signal a much further decline ahead.

If you’re a new investor or have capital you’d like to add, this could be an opportunity for you, especially if we have a steep decline and the Fed backs off from rate hikes.

What else could happen? The Chairman of the Fed is Jerome Powell and he will be under intense pressure to stop their present course. Pressure is not surprisingly coming from the White House as well as the Fed is a threat to kill the Presidents economic agenda.

If Powell signals that the Fed is done with raising rates then a move to 3000 in the S&P 500 and a sharp sell off in long term treasury bonds is not impossible. Stay tuned. But my guess is there will be considerable damage done first.

Powell was appointed by Trump and it’s my understanding he can be fired as well. A firing would be considered a major positive event for risk markets.

Time will tell and this period will pass as well. It’s a time to be very cautious and hedged against risk.

We are positioned to protect our client accounts and benefit if a major decline occurs.

The irony of all of this is I didn’t even mention Trade Wars. But they’re easy to win so it’s all good.

Brad Pappas

Disclaimer; Socially Responsible Investing