2/21/21
S&P 500: 3907
Nasdaq: 13,874
10 Year Treasury: 1.3%
David R. Snyder, CFA
We are in the last phase of the first year of a bull market. In the past after recession induced bear markets, the first stage of a new bull market has consistently lasted for one year give or take a month on either side. Since this new bull market began last year on March 23rd, the first stage is likely to end between February 23rd and April 23rd. I lean towards the end of that two month period.
The first stage of a new bull market is the period of highest returns for the stock market especially in the high beta speculative names that benefit from a recovery in the economy. The one year returns average over 50% even on the less volatile S&P 500. Yes it is historically a better time to invest than the last stage of a bull market. Last year near the bottom I recommended with strong conviction riskier high beta assets while everyone else was recommending staying with high quality. High beta has outperformed low beta from the March bottom by one of the largest margins in the history of the stock market. That is the good news but the bad news is that is all about to end within the next two months.
The second stage of a bull market which will begin by the end of April has historically been a period of digestion and correction for at least three to five months. The corrections are usually correlated with how much the stock market has increased in the prior year. Based on the 80% plus return of the S&P 500, expect an approximate 15% correction between April and August with a bottom likely between July and September. During this time period low beta will outperform high beta. But even after the stock market resumes its advance after the correction, high beta will have a more difficult time outperforming low beta but especially so for the very speculative stocks. They are a ticking time bomb.
Value has only slightly outperformed growth this year as investors came roaring back to the hypergrowth stocks the last couple of months. It appears that investors are playing these Covid beneficiary stocks right up to their last easy year over year earnings comparison in the March quarter and not discounting ahead. The only Covid beneficiary stocks that have underperformed in the last six months are consumer staples and some of the largest cap tech stocks that have lower betas. Value will begin to show strong outperformance when the last phase of this first year of a bull market ends if not earlier.
When I called for a correction in the last days of January part of my thesis was that interest rate rises would cool off for a short time period (actually wrote about it earlier). Which did happen but when the Covid cases began to decelerate and the $1.9 trillion package became more likely to pass, my view changed to a resumption in rates rising. Daily new cases have peaked in early January as I forecast last year and are decelerating even faster than even I expected.
In my opinion we are providing too much stimulus to the economy especially in the context of being near the end of the coronavirus epidemic. The government money could have been much better targeted to those really in need, reducing the overall amount significantly. We have added over a trillion dollars since last March to middle and upper class household savings who were not negatively affected by the virus. We will eventually pay for this overspending. Money doesn’t grow on trees. But in the short term the economy will surge this spring and summer, causing rates to move higher. The only offset is that US Treasury rates have the highest historical spreads to other developed countries sovereign rates such as German bunds.
Last year near the stock market bottom when earnings estimates for the S&P 500 bottomed at under $140 for 2021, I forecast that earnings estimates would rise by at least 20 to 30% for 2021. Already earnings estimates have moved up to close to $180 for this year which is 28% higher than last year’s estimate in late March. Estimates will go even higher.
There has been continued debate over the role of the small investor in the financial markets. But the small investor speculation signal to the stock market is not really debatable and has withstood the test of time. There really is not much difference between Yahoo chat rooms in 2000 and the Reddit social media postings today. They both reveal froth and speculation. The testimony from Keith Gill who was behind the Reddit postings that caused a short squeeze in Gamestop (GME 41) just increased my conviction that these investors are not sophisticated. His explanation for why GME was undervalued was weak and superficial. I would bet he simply jumped on the back of famous hedge fund Michael Burry’s recommendation to buy GME. Furthermore it appears he invested most of his money in GME. And he is a role model for investing? Putting most of your savings in one extremely risky stock? Please folks, spare me.
The irony is that the Robinhood investors made wealthy investors wealthier instead of robbing the rich. Insiders who are generally very wealthy unloaded significant portions of their large stock holdings in these short squeezed stocks at very high prices, enriching them. And most of the short sellers other than Melvin Capital were able to hold on to their short positions. Then there were sophisticated hedge funds who shorted or bought puts in these stocks after they exploded. Meanwhile the average prices that retail investors paid for these stocks are already significantly higher than the current stock prices, and they are going lower.
Even worse the Robinhood and Reddit investors were encouraged by their favorite investor, Chamath Palihapitiya, to continue the short squeezes when he announced he was buying calls on GME after the stock had already soared. Yes Chamath is CEO of Social Capital, the disingenuous common man’s billionaire. The same guy who divorced his wife and now has a girlfriend who is an heiress to an Italian pharmaceutical fortune that produces the sixth most expensive drug. In 2018 there was a mass exodus from his firm because he decided to spend most of his time with the heiress girlfriend. The same guy who just invested in Clover Health with a SPAC and failed to disclose DOJ investigations, kickbacks and overcharging by the company and its management team. The same guy who praised the sophistication of the Reddit investors. He is all about the little guy while he makes billions and hangs out with the super rich. And he is their role model?
I enjoyed hearing from these new investors that they were as sophisticated as me with regard to investing. They enabled me to make a lot of money for my clients. I sold a lot of the stocks with large short positions that my clients owned before the Reddit postings that caused the short squeezes. Lumen (LUMN 12), Blackberry (BB 12), Shake Shack (SHAK 124) and Bed Bath & Beyond (BBBY 26) all increased 50% or more in less than a week. Sold them at the 50% increase mark and then turned around and bought puts on BB at $13, BBBY at $40, and GME at about $150. Even though the premiums were extremely high for the puts I am well ahead on all of my put positions. And they are all going lower. Making money on both sides of the trade. Thanks for your diligent research Reddit members and Robinhood clients.
As for Melvin Capital, the hedge fund that lost a significant amount of money as a result of closing out their very large short position in GME near the top, they violated every rule of short sale investing. First I only invest 1% of a portfolio in each short position, on rare occasions 2%. When an investor is short, his/her potential losses are unlimited. If there is only a 1% position and the stock triples from a short squeeze I can still hold the short without too much damage to the overall portfolio. Not so with a 5 or 10% position. The best strategy is to design a synthetic short sale by buying an in the money put position. This limits your losses to the amount of the put.
Another strategy especially for volatile stocks is to buy an out of the money call against your short position. When GME’s stock price was $10, Melvin Capital could have bought GME 20 calls out a year for pennies. For just a very small cost the hedge fund could have been fully protected from GME going above $20. From my reading Melvin Capital appeared to have a very large short position in GME before the short squeeze. The other mistake was not transferring his short position to a put position knowing with a high probability the stock would eventually retreat. It would have cost them a small amount of money relative to the short position.
The best signal that we are in a speculative bubble is the performance of the ARK funds over the last year. The funds managed by Cathie Woods, have been the best performing ETF’s over the last year. They only invest in hypergrowth companies that are disrupting industries. Their flagship ETF has outperformed Nasdaq since its inception in 2014 but only by a moderate amount pre-Covid. The funds benefitted immensely from Covid and had a spectacular year in 2020. Their assets under management have grown from $3 billion to just under $60 billion in a short time period. Now she has become a rock star and the Reddit and Robinhood investors follow her every move. She actually reveals her buys and sales each day.
The ARK hysteria is so reminiscent of the Janus funds in 1999-2000. The Janus funds had spectacular returns in the late 1990’s only to fall from grace therafter. The Janus 20 fund was their flagship fund and only invested in hypergrowth internet names. Its returns from 2000-2002 were abysmal and never really ever recovered.
Just last week Barron’s featured a fund manager who also was a star in the late 1990’s only to subsequently perform poorly. He was somehow able to hold on and has posted very good returns for the last seven years. However just the fact that he is being featured again is very eerie.
There is a time for hypergrowth companies and there is a time not to invest in them. This is not the time. Barron’s this past weekend observed that high growth software companies are selling on average at 44 times next years sales. Yes I wrote 44 times sales, not earnings. That is a high threshold to overcome. Any little slip will cause these stocks to decline 50% or more very quickly.
Full Disclosure: I own several of the securities mentioned positively. None have been purchased within the last month. The opinions merely represent the opinion of the author as CIO of Journey 1 Advisors, LLC and intended to inform the readers about our investment philosophy and strategy. The contents of this report are based on sources believed to be reliable. It is not intended for circulation. It is not intended to offer investment advice, or to recommend the purchase or sale of any securities or investment product. Investment advice is only given after a client has signed an investment advisory agreement with Journey 1 Advisors, LLC and will be subject to the terms and conditions therein. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock’s expected performance and risk.