Wesley Chapel, FL
The S&P 500 finished July up 9.21% (using the SPY ETF as a proxy) for the month. That is still below where it closed for the month of May. So, even though it was a good month, 9.21% was not enough to recover all of what it lost by being down 8.64% in June.
That’s right, if you start with $100 and you lose 8.64% you are left with $91.36. If you then earn 9.21% from there, you finish with only $99.77. The bigger the loss the harder it is to recover. As a simple example that is easy to remember – if you lose 50%, you need 100% gain from there just to get back to even. If you lose 80%, you need 400% gain from there… again, just to get back to even.
This is why we spend so much time and effort trying to avoid major losses at Elevate. It is a big part of the reason that we use trailing stops. But it isn’t the only reason.
Another big reason that we use trailing stops is counterintuitive. We use trailing stops so that we can hold on to our best positions for longer than we otherwise might.
Think about it this way, if you buy a stock for $100 and it doubles in price to $200 many people would be tempted to sell that stock thinking “how much higher can it really go?”
Well, the answer is “infinitely.” There is no limit to the upside in the stock market. Stocks can and often do go higher than anyone thinks possible, and they certainly go higher than any fundamental analysis of valuation would indicate to be reasonable.
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So, in our case, if we start with a stock at $100, and for example we use a trailing stop of 25%, our stop starts at $75. If the stock drops and closes below $75, we sell the next day. (We generally would set an alert to rebuy that stock if we really liked it for the long run somewhere under the original $100.) But if the stock instead goes up to close at $150 our stop moves up with the price. That is the “trailing” part of the stop. The trailing stop is always based on a percentage from the highest closing price, in this case 25%. So, with the highest closing price of $150, our stop would be $112.50 – a gain of 12.5% from our entry at $100.
And if the stock drops from $150 down to $120, again many people would be tempted to sell for the 20% gain before it goes even lower. But so long as “the story hasn’t changed” for that stock we would continue holding. If the stock then bounces from $120 up to say $200 for example, our stop will again move up to $150 – 25% below $200 but a 50% gain from our entry price of $100. This “gives us permission” to hold stocks for the longer term without having to worry much about whether they are overvalued or not.
From there, we won’t sell unless either a) the story changes with that stock, or b) it closes below our stop of $150.
We don’t always (or often) use 25% as our stop loss percentage. That would be arbitrary and wouldn’t make much sense. Instead, we use the historical volatility of a particular stock to tell us what the normal range of fluctuation is for that stock.
So, for example, the current historical volatility for Tesla (TSLA) is 55%. That means over the past few years, it is actually normal for Tesla shares to drop 55% from their highest point before recovering and going higher.
On the other end of the spectrum is something like Hershey (HSY). Hershey’s historical volatility is around 17%. Again, it would be normal for HSY to drop by as much as 17% before recovering and going higher.
In either case, if the stock price drops by more than its historical volatility it is abnormal. That is enough for us to sell (whether for a big gain or a small loss) and look for a re-entry point after it settles down, assuming we still like the company in the long run.
When one or two stocks behave abnormally, it is no big deal. But when several of our positions start to behave abnormally, we see that as a leading indicator that something has changed in the overall market structure.
That is what started to happen late in 2021 and early this year. It is a large part of the reason that we made the decision to hold substantially more cash than normal. Another factor is that our re-entry alerts were not telling us to get back into many (really any) of these “best in class” stocks.
Buffett’s CVS trade. “SSI” on this chart is essentially the “volatility based” trailing stop.
SOURCE: tradestops.com
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Before I move on to the next important role that historical volatility plays in the design of our portfolios, I want to reiterate that stock prices can go higher (or lower) for longer than anyone (including me) thinks possible. And they often do. Some of the best investors in the world use valuation models or gut instinct to decide when to sell their stocks. Sometimes they are right but often they are wrong and sell too early. See the nearby chart showing the entry and exit price of an investment in CVS made by none other than the “Oracle of Omaha” himself, investment guru Warren Buffett.
The main takeaway here is that we don’t use trailing stops because we are active traders. On the contrary, we use them to give us permission to hold onto our best ideas for longer than we probably otherwise would.
Most firms allocate capital. That means they start with $100,000 and allocate 100% of that by picking their best funds or stocks and then choosing a percentage to allocate to each one until they get to 100% allocated. (I have outlined more than once in this commentary why most firms don’t ever hold much cash, so I won’t do that here.)
At Elevate, we don’t allocate capital – we allocate risk.
What I mean by that is that we have a set limit of how much we are willing to risk on any one position. For example, let’s say that limit is 2%.
This means that in a $100,000 account we are willing to risk $2,000 on any single holding. That risk is essentially controlled by the trailing stop loss.
If we are willing to lose a max of $2,000 and we also want to own Tesla, that means we must invest an amount in Tesla where if it dropped by 55% (as indicated by the historical volatility) we would lose no more than $2,000.
The math isn’t too hard. We just take the dollar amount we are willing to lose ($2,000) and divide it by the historical volatility or trailing stop percentage (55% or 0.55).
$2,000 ÷ 0.55 = $3,636.
So, if we start with $3,636 and Tesla immediately drops by 55%, we will have $1,636 [$3,636 x (1-.55)] left and will have lost $2,000.
By contrast, if we are willing to lose the same $2,000 on Hershey with its historical volatility of only 17%, we can afford to invest as much as $11,764.
$2,000 ÷ 0.17 = $11,764
Again, if we invest $11,764 and Hershey stock drops by 17%, we will have $9,764 [$11,764 x (1-.17)] left and will have lost the same $2,000.
So, while most firms allocate dollars and hope for the best (they call it “Asset Allocation”) with no sell rules of any kind, we allocate the risk and manage that risk accordingly.
In the example we just went through, our allocation to Tesla would have been a relatively small 3.63% and our allocation to Hershey would have been a relatively large 11.76%. But the risk allocated to each position would have been identical. This is referred to “risk parity” in the financial world.
It makes perfect sense that we can “afford” to put a lot more money into stable stocks with decades of profitability like Hershey than we can in expensive and extremely volatile stocks with limited history.
Trailing stops are just one aspect of our portfolio management strategy at Elevate. The benefits of using trailing stops are many:
Trailing stops get us out of stocks that are going down before they drop too far.
Trailing stops keep us in stocks that are going up for longer than reason would allow.
Trailing stops help us hold onto profits in stocks that go up.
Stops (whether trailing or not) help us to determine how much capital we can afford to allocate to a position.
A couple final thoughts on stops and allocations:
Historical volatility changes daily and is updated weekly for our positions. So, as time goes on our trailing stop percentage changes. The percentage can increase or decrease and based on that we sometimes must reduce our position size (when volatility climbs), or we can get permission to increase our positions size (when volatility falls)
Sometimes we do select a specific percentage trailing stop that is different from what the historical volatility would call for. In the Hershey example I provided, since we will probably never put 11% of either strategy into one stock, we can afford to use a wider stop and allocate fewer dollars. We generally do this with “World Dominating” types of companies that we ideally want to hold forever.
In certain market environments (like the one we find ourselves in today) we tend to use tighter “hard” stops at specific levels that a stock has dropped to but hasn’t gone below recently. In these environments we also tend to start with a partial position rather than a full allocation immediately. If the stock doesn’t drop below the hard stop price, we will look for opportunities to add to that position whether on dips or on strength.
To illustrate, if we plan to put 6% into a position, we might start with a 2% allocation and then look to add another 2% later, and then another 2% after that.
Additionally, we switch from a hard stop to a trailing stop when the price of the desired trailing stop (whether volatility based or percentage based) rises above the level of the hard stop.
With that in mind, we have been buying stocks since the end of June. Across both the Growth and Value Strategies we have added 12 new positions. We have started with only fractions of our target allocations – so we have room to add to every single one of our new positions if they continue to “behave,” which means that they stay above their current stop levels.
We still have plenty of cash to put to work, but I am not confident that the current bear market is over just yet.
There are always reasons to be bullish and there are always reasons to be bearish. In no particular order, less than exhaustive lists follow:
Reasons to be bullish:
Sentiment had/has become too bearish. When everyone who wants to sell has sold, all that remains are buyers. When there are more buyers than sellers, the market goes up as buyers bid up the price of everything.
Speculation that the Federal Reserve Bank (FED) will pause or slow their interest rate hikes because inflation peaks and begins to fall.
Stocks (and Bonds) are on sale compared to their prices from November.
Unemployment rate continues to fall despite interest rates rising.
Market has rallied over the past couple weeks!
Reasons to be bearish:
Fed Funds Rate & Expectations
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1 - Interest rates continue to rise which reduces the present value of any cash to be received in the future. The higher the interest rate, the lower the present value of cash to be received in the future. Higher interest rates also mean higher interest payments on credit cards and home equity lines of credit and other floating rate debt held by corporations. That means less money to grow their businesses, pay dividends or repurchase shares.
Fed Balance Sheet
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2 - The FED is reducing its balance sheet and the pace is set to accelerate. The FED stopped replacing maturing bonds on June 1, 2022, at a rate of about $47.5 billion per month. That rate is set to double after three months. So, on September 1, it will jump to $95 billion per month. Remember, the only other time the FED tried to stop buying bonds, letting its current holdings mature and “roll off” the balance sheet was in 2018. That was the last down year for the market.
3 - The highest inflation in four decades continues to squeeze consumers. This is why companies like Walmart are slashing their profit expectations as they see customers spend more on essentials and less on discretionary items. Check out this quote from a recent article in the Wall Street Journal:
“If I have one medical emergency or one of my cats has a medical emergency, that’s it,” Ms. Banigan said. “It will be a choice between the groceries and Deborah’s medical bills or the cat’s vet bills.”
Labor Force Participation Rate
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4- Labor Force participation rates are falling. Even though the unemployment rate has fallen once more to the historically low level of 3.5% - almost 40% of able-bodied people in the USA are not only not working – but they aren’t even looking for a job.
5 - Automobile repossessions are climbing. Edmunds says that almost 13% of new car buyers are making monthly payments of $1,000 or more. This compares to the monthly median mortgage payment of $1,600.
On top of that, loan-to-value ratios are topping 130% which means that the value of the car is less than the amount owed to the bank. For example, imagine owing $39,000 on a car that is worth $30,000. That would be an LTV of 130%. At these levels, even 4% of prime borrowers (people with good credit) are just leaving the keys in them and defaulting on their loans. The default rate for subprime borrowers jumped from 6% to 11%.
6 - Wealth Effect. The "wealth effect" is the notion that when households become richer as a result of a rise in asset values, such as corporate stock prices or home values, they spend more and stimulate the broader economy. The opposite is also true.
Smart vs Dumb Money Confidence
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7 - “Dumb Money” confidence is high relative to “Smart Money” confidence according to sentimentrader.com. Without getting too carried away with what makes up either category, the important thing to note is that so far during this bear market when dumb money has gotten more confident than smart money, the market had reached a near-term high and then began to fall once more.
8 - Company profit outlook… Walmart and Target have too much inventory and need to sell it for lower prices while their costs are rising. That means profits are being squeezed. You can read Walmart’s profit warning here, and Target’s “inventory optimization” plan here.
GDP over time
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9 - GDP contracted in the second quarter of 2022 for the second consecutive quarter. As I mentioned way back in my April commentary this isn’t the “official” definition of a recession, but it is certainly the unofficial definition. And it is pretty clear to me personally that we are in a recession and have been for a while. As I also said in last month’s commentary,
“The people we are supposed to trust to guide our economy are failing to manage risk while “betting the farm.” You can’t make it up. And somehow, we are supposed to trust them when they say that they can orchestrate a “soft landing” for the economy now. The soft landing is defined as reducing inflation without causing a recession. I think they only way they can do anything even remotely close to that is if they get their friends over at the NBER to simply not declare a formal recession.”
Whitehouse.gov statement on recession
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Well, it looks like the White House and the FED are working hard to get those friends to not declare a recession. Just take a look at this statement posted by the White House ahead of the second quarter GDP release. FED Chairman Jerome Powell went on to say (after raising the Fed Funds Rate by another 0.75% on July 27th):
“2.7 million people hired in the first half of the year, it doesn’t make sense that the
economy would be in recession…”
With as much respect as I can offer, this is the same guy who told us that inflation was transitory for the better part of a year while he and his pals continued to print money to buy bonds pushing prices ever higher before finally admitting being wrong. I suspect that if we could get more than 60% of the population to either actively work or look for work, this number would be much higher.
One other thing, Mr. Powell, the vast majority of the jobs added in the most recent report were either part-time jobs (384,000) or second jobs (92,000). The economy actually lost 71,000 full-time jobs according to the last report! Sounds healthy…
10 - 30-day and 90-day credit delinquencies are rising across the board according to the Federal Reserve Bank of New York. It would be even worse if student loans payments weren’t still being waived due to COVID-19.
According to Bloomberg, “The pandemic-era freeze on student debt payments has ‘dramatically’ improved credit scores for Americans who borrowed money to pay for college, the Federal Reserve Bank of New York said. The article goes on to say that balances are growing with larger balances making up a larger share of the overall debt.
What could possibly go wrong?
11 - The yield curve is more heavily inverted than at any time since August 2000. This means you can get paid a higher rate of interest loaning the US Government money for 2 years than you would get paid to loan the same government money for 10 years. This setup generally precedes recessions.
12 - According to Hussman Funds, stocks are still expensive relative to history, they just aren’t quite as expensive as they were back in November 2021. This year’s decline has only erased the frothiest portion of the recent bubble which has brought S&P 500’s price to sales ratio back to its 1929 and 2000 extreme levels.
13 - Lending standards are tightening which is another metric that has consistently preceded or coincided with recessions. So, not only is it more expensive to get a loan due to higher interest rates, but it is harder to even get a loan as banks are more cautious about who they will lend to. This serves to reduce economic activity overall.
14 - Technical analysis shows that the market rally over the past couple weeks has run into some resistance (much like it did earlier this year) setting up a potential drop from here. Whether it drops or breaks out higher is anybody’s guess. But given that the S&P 500 is still trading below its 200-day moving average and that moving average is declining - there is no arguing that the market is still in a longer term downtrend. As we saw back in the bear market of 2008-09, some bear market rallies can see the markets climb by 20% or more before ultimately rolling over to a fresh low.
I could probably go on and on with reasons to be bearish… I didn’t even mention the world’s reaction to Russia/Ukraine conflict, or the recent developments with China/Taiwan in those 14 points. I am personally still bearish. I think we could easily see new lows this year before it is all said and done.
Tomorrow, we will see what the CPI (inflation) data looked like for the month of July. If it comes in lower than expected (9.1% in June and expectation of 8.7% for July) the market could rally some more. And it also might not. But 8.7% is still much higher than the FED’s stated 2% target and with unemployment falling to 3.5% the FED should continue to raise interest rates in the near term.
The FED will probably take some credit for inflation slowing (if it is in fact slowing) but FED Governor James Bullard is now calling for the Fed Funds Rate to go up to 3.75% to 4.00% by the end of this year. Previously he had said he wanted to see the rate at 3.50%.
As much as I would love to get into the new “Inflation Reduction Act” which basically approves a bunch of new spending of money that we don’t have (and therefore must be printed) which will cause inflation to worsen or at best remain persistent, I have gone on too long about other things, and I need to wrap this up.
I remain focused on protecting the capital with which you have entrusted Elevate while scouring the market for investment opportunities to grow your wealth with acceptable risk/reward characteristics.
Update: Despite my best intentions to get this written, edited, approved, posted and sent (yeah, it is a bit of a team effort every month to produce this) last night (August 9th) it is now August 10th and the CPI numbers for July have been released. As I sort of expected, July CPI came in at 8.5% for all items, less than the 9.1% from last month and also lower than the 8.7% expectation. The market is initially rallying on this data. But, again, reality will take a few days to sink in - 8.5% is still much higher than the 2% target. This does not mean prices are falling, it just means they aren’t rising as fast. This, along with the low unemployment rate gives the FED permission to continue hiking rates. And as I have outlined, as rates go higher prices tend to come down - that means prices of stocks and bonds, too.
Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed in July.
Until next time, I thank God for each of you, and I thank each of you for reading this commentary.
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor
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