Wesley Chapel, FL

I wonder if Chairman (of the Federal Reserve Bank) Jerome Powell, reads my commentary. It wasn’t long after last month’s note that Mr. Powell changed his tune on inflation being “transitory” and shifted his stance toward “tapering” the central bank’s bond purchasing program faster than planned.

The S&P 500 index didn’t like this change of tune, but it recovered quickly without even so much as a 5% drop from its all-time highs. The index has yet to climb back to a new all-time high, but it seems to be working on it.

Interest rates probably should have rallied higher on the news of the taper speeding up. But instead, the yield on the 10-year US Treasury fell from around 1.53% on Monday the 29th of November (before his comments) to a low of 1.34% on December 3rd. That is a drop of 12.4%...

Let’s be honest. Rates this low are hard to even consider “rates.” They are closer to zero than they are to the average since 1958 of 5.83%. Which is unreal. At the same time, inflation is now higher than its average of 3.62% over the past 60 years. Even more concerning is that “real” interest rates, which is what we are left with after subtracting the rate of inflation are negative! In fact, real interest rates are more negative today than they have been since the late 1970’s when inflation was almost 20%, as shown in the image below.

There seems to be a “new paradigm” taking hold of the markets, which is especially scary given the other chart further below showing various stages of the market cycle. The new paradigm often promoted suggests that the market will never again drop by 20%, let alone a drop of something “crazy” like 50%.

If history is any indicator, the market can drop by more than 20%… and it will. The only things we don’t know are when it will happen, how fast it will happen, and for how long it will last.

If you look back to March of 2020 (which is ancient history for many), when people first got spooked by COVID19, the market dropped about 30% in 30 days, before the government could step in and save the day. Over a three-and-a-half-month period, the US Central Bank printed more than 3 trillion (with a “T”) dollars.

To put that into perspective:

It would take 31,709 years for 1 trillion seconds to pass.
It would take 95,127 years for 3 trillion seconds to pass.
Said another way, if you never slept, or ate, or did anything other than count 1 second at a time, you’d have to live to more than ninety-five thousand years old to count all the dollars our government printed in that three-month period.

Every dollar the government has ever had represents a tax. They don’t produce anything, they don’t sell anything, they don’t provide any services and they don’t have any money that they haven’t taken from someone else. The worst part about inflation is that it is a tax which is disproportionately paid by the poorest Americans who don’t own any real assets or stocks. And that is (at least partly) why income inequality will only continue to worsen.

And what did they do with all these dollars? Mostly, they bought bonds. They did also give some away in the form of stimulus checks and enhanced unemployment benefits, but that was small in comparison to what they spent buying bonds to keep interest rates low.

And now, the only way to take some of that money out of circulation is to start selling the bonds they bought, and then essentially lighting on fire the dollars they take in from those sales. I wouldn’t hold my breath on that happening any time soon.

Remember, we have seen this movie before. Back in October 2017 the FED (much to the dismay of then President Trump) started allowing some of the bonds they owned to mature, without replacing them. This had the effect of reducing their balance sheet. They called it Quantitative Tightening (QT) which is the reverse of the bond buying programs which are called Quantitative Easing (QE).

During the fourteen months from October 2017 to December 2018, the S&P 500 index dropped almost 7% at its lowest point. That included a drop of more than 20% from October to December 2018.

S&P 500 performance during Quantitative Tightening (QT)
SOURCE: Tradingview

Quantitative Tightening (QT) Highlighted with red box
SOURCE: JP Morgan Guide to the Markets

At that point, Trump (and many others) were concerned that QT was the reason for the market’s struggles and the pressure was on to end the program. News and speculation of the early termination of the QT program is probably what stopped the market from dropping even further.

Anyway, the point I am trying to make is illustrated well in the image below. It shows the market’s stages along with key investor sentiments during those stages. And what you really want to look out for is the “new paradigm” sentiment.

Today, I frequently encounter folks talking about new paradigms like “we’ve never had this much money printed before,” and “if the market goes down, we will just print more money,” or “there have never been so many retail investors trading stocks,” or “crypto will save the day,” or “Modern Monetary Theory (MMT) is the way forward.”

I am not saying that we are for sure at the peak of this market cycle. We can never be sure until it has passed. But I do know that I have heard the “new paradigm” sentiment more than usual, lately. And I also know that the last time we had a real scare in the market (COVID – 3/2020) it dropped a little over 30% before the FED was able to print enough money to stop and reverse it.

There is no reason we can’t drop 50% in a hurry. And maybe next time the market won’t recover so quickly. When the mortgage bubble burst in 2008 and the Great Financial Crisis ensued, it took the S&P 500 nearly 2,009 days (or 66 months, or 5.5 years) to get back above its 2007 peak value. The index initially dropped 57% in 518 days (think about that compared to the 30% in 30 days of the COVID drop) and then rallied more than 135% over the next 1491, days to get back to even.

Global Financial Crisis performance of S&P 500 index.
SOURCE: Tradingview

Sure, that is when we were first introduced to QE, and things like TARP, where the government backstopped companies that had gambled and lost. And maybe that playbook will work forever, and we will never again have a lasting bear market. But I somehow doubt it.

The good news is that Elevate has historically done some of its best work during market drawdowns. This is when we generally hit stop loss triggers on our holdings early in the process and have a ton of cash to invest when we finally get to the bottom. By then, the world has typically changed in some obvious way, and we have a shopping list of new stocks ready to reload for the rally that will follow when everyone who wants to sell has finally capitulated and sold.

I am not calling the top of the market now. We don’t pick tops or bottoms. We wait and follow the rules that we have developed and have served us well over the long-term. But this is starting to feel like a house of cards to me. A bear market is nothing to be afraid of or anticipate. It is something to be prepared for and maybe even excited about. Its just a normal part of market cycles and I would love to get back to some sort of “normal” as it relates to markets and fundamental valuations.

But we also must be prepared for the market to stay irrationally exuberant. It can do so for longer than anyone thinks possible, myself included.

Performance

The Appreciation Strategy had a tough month in November, down more than the S&P 500 and we stopped out of three positions. One of which we had held since February 28, 2020 – near the bottom of the COVID market crash. Even though we stopped out, the stock (MercadoLibre: MELI) was up 107% during the 635 days we owned it. And we trimmed some at much higher prices along the way. Not only was that a nice long-term win, but MELI subsequently dropped another 20% after we sold. It could easily slide even further.

The other two (Paypal: PYPL and Disney: DIS) unfortunately represented losses overall. On the bright side, PYPL continued to drop another 16% after we sold.

I decided to sell only half of DIS. It also kept falling and we nearly stopped out of the second half, too. But it has since recovered about 9% from the lows and we are back to our original stop where we sold half. I will continue to keep a close eye on DIS, but it is a long-term favorite with diversified businesses that together can do well whether the world is locked down (Disney+) or reopened (Theme Parks.) Disney is down 25% (we are down only 13% from where we bought) from its highs earlier this year and would need to go up by about 31%, just to get back to the high. We are essentially risking about $12 to make $50 (or more).

It is hard to find stocks I like in this market environment. Many momentum stocks (like MELI) have lost their momentum while the indexes just keep grinding higher despite governments shutting down parts of the economy due to fear of COVID variants, and the threat of the FED raising rates by tapering bond buying programs. And these days it is very hard to find growth stocks that are priced fairly. For that reason, we recently decided to buy a couple of exchange traded funds representing the Healthcare and Financial indexes, over taking our chances with more individual stocks. We did find a few “cheap” stocks in Meta Platforms (formerly Facebook: FB) and Lam Research (LRCX) which are both extremely capital efficient. So, we initiated small positions. More recently we also added Virtu Financial (VIRT). The appreciation strategy is essentially max long and carrying very little cash.

The Income Strategy also missed the mark in November but has beat our expectations for the full year. We are up more than half as much as the S&P 500, but perhaps more importantly with only half the risk of the index. Asymmetrical risk vs. reward is the name of the game.

We did stop out of one name (Bristol Myers: BMY) in the Income Strategy in November, but very quickly replaced that with one of our long-time favorites, Cisco Systems (CSCO). We also added a position in Quest Diagnostics (DGX) which is a fairly priced stock that is benefiting from testing for COVID.

Outlook

My outlook is largely unchanged. Inflation is high and increasing, but perhaps at a slower rate. GDP is also rising. When the rate of change for GDP is growing and inflation is slowing compared to the most recent quarter, that is the best situation for the economy. Many call it the “goldilocks” scenario.

At the same time, the market is trending higher (with only very small dips) and remains terribly expensive.

Stocks are as expensive now as just before the dotcom bubble popped.
SOURCE: JP Morgan Guide to the Markets

Long-time clients know that the combination of “Uptrend x Expensive” is the second-best of four scenarios for the market.

So, for now, we stay long. We stay focused on capital efficiency (the ability to grow revenue without spending much) and we keep a very close eye on our stops.

Until next time. I thank God for each of you, and I thank each of you for reading this letter!

Merry Christmas!

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor

Legal Information and Disclosures
This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.