When the Levee Breaks | Momentum, Threads & Trafficking

Relatively short one this week as I had some long overdue personal business to attend to.

Here’s a reminder to make sure you take the time to focus your energy and attention on what really counts.

Momentum

Momentum in the investment arena can be a slippery concept. Often dismissed by "serious and professional" investors, it's viewed as the unruly counterpart to their more refined strategies.

The discerning, measured approach of veteran investors like Warren Buffett, who champion value investing, contrasts starkly with the seemingly capricious nature of momentum. 'Value' is often considered the antithesis of momentum, with 'growth' serving as a mediating hybrid, bridging the gap by focusing on companies demonstrating substantial earnings or revenue growth.

While value investing, an 'intellectual' pursuit of purchasing companies at prices significantly below their net value, might sound appealing in theory, it's the practical application that poses a challenge. Estimating the intrinsic value of a company and discerning whether the discrepancy between current and 'true' value is temporary or more lasting involves forecasting, which is fraught with uncertainty. Remember the corporate casualties of societal or technological change, like Eastman Kodak, GE, or Compaq Computers?

On the other hand, momentum investing simplifies this process by adopting a more intuitive philosophy - the notion that stocks on the rise will continue their ascent. Indicators like the Relative Strength Index aid momentum investors in pinpointing promising stocks - a physics principle applied to finance, if you will.

Despite its 'unsophisticated' appearance, momentum investing often outshines value and other investment strategies. Prominent figures like John Henry, owner of the Red Sox, have amassed fortunes in the macro markets using this approach.

Simply put, robust stocks tend to become more potent, while weak stocks often dwindle further.

Momentum's success can be attributed to various systemic factors. Money managers often exhibit herd-like behavior, gravitating towards flourishing stocks and shunning the underperformers. At the end of the quarter or year, investors favor seeing their funds in 'winning' stocks, even if they've missed the majority of the upswing. This is why I recently speculated that tech stocks, despite rising headwinds from high rates and inflation, would sustain their strong performance or at least maintain their current levels.

At the end of the 2nd quarter, funds have to release a 13E reports which details their stock holdings. Therefore, you tend to see people piling into the names that did well the last quarter or two - names like tech giants Nvidia, Facebook, Tesla, Microsoft and Apple.

Those names are the companies that have carried the indexes higher over the past 6 months.

They also happen to be the biggest components of the the S&P 500, which is a market weighted index.

1 That means 10 stocks or so make up a huge part of the index.Now that the quarter is over, I expect the slow rollover to begin and for indices and stocks to head lower.

People keep asking me what are the ‘headwinds’ I’m referring to. We speak about topics like this every week in my Alpha360 group. A super-brief synopsis is to think of markets like an airplane - their speed is either helped by tailwinds, or hurt by headwinds.

For the past 40 years, the equity markets have enjoyed substantial tailwinds. The Baby Boomer generation, the wealthiest in history, has served as a robust engine, pouring capital into stock markets during their peak earning years.

Furthermore, we've experienced an unparalleled bond bull market, with interest rates plummeting from 18% in the '80s to virtually 0% today. Low-interest rates foster capital formation, enabling both businesses and individuals to borrow and flourish, thereby fueling sectors like real estate.

Adding to the windfall, China has been instrumental in keeping inflation at bay as the world's manufacturing giant. The global market has also expanded significantly, thanks to the fall of the Soviet Union, leading to a 'peace dividend' as countries redirected defense spending towards modernization.

Sadly, many of those tailwinds haven’t just stalled - they’ve reversed, transforming into significant headwinds.

Interest rates have surged and are at 5.25%, marking their quickest ascent in decades. The average 30 year mortgage is 7.50%. That's a killer for home buyers.

The Fed has made clear they are going “higher for longer”, meaning they will continue to raise interest rates until they feel comfortable about the inflationary crisis we’ve endured since the beginning of the Biden Presidency (a combination of pathetically stupid policies, years of Federal Reserve mismanagement, and a completely unnecessary war in Ukraine we pushed for and have prolonged).

Russia, China and the BRICS nations are actively challenging the U.S. dollar.

The U.S. is $31 trillion in debt and running deficits for as far as the eye can see.

We just had the second largest bank collapse in the U.S. and global superbank names like Credit Suisse needed to be bailed out overseas.

The commercial real estate sector is a well known donut and losses will exceed $2 Trillion dollars.

China and the US are now in a technology war with the US limiting sales of chips and other key technological components to them while China embargoes rare metals that we need to build those chips and electric vehicles.

Moreover, the retiring/dying Boomers are withdrawing money from the stock markets, further straining them to pay for their living expenses. ‘Demographics is destiny’ is a maxim that bears repeating.

All of these are ‘headwinds’ that the US economy and especially stock markets must contend with.

The 3 most important factors for the stock market are:

• Earnings
• Interest Rates
• GDP (Gross Domestic Product)

These 3 factors carry the most weight over time and should dictate the direction of the market not accounting for exogenous shocks (pandemic, 9/11, nuclear war, aliens, etc).

Right now, none of them are working in our favor.

Interest rates, instead of being accommodative, are high and expected to rise further. Earnings have begun to dwindle, a first in a decade (excluding the pandemic shock year). The GDP, too, is feeble, indicating a looming recession.

Sure there are lots of secondary and tertiary factors....commercial real estate and bank collapses. The war in Ukraine. Market sentiment a big one. Employment (still strong).

But those 3 factors above carry the most weight when forecasting stock performance.

It’s still a Tale of Two Economies as we've spoken about before. The top 10% are remarkably well off, and spending like crazy on travel, entertainment and luxury good.

The rest of the country is taking second jobs in order to deal with crushing inflation and wages that can’t keep up.

To get an idea how expensive the market is, take a look at the Shiller PE.

The Shiller PE, named after economist Robert Shiller who famously called the housing bubble, gives you a longer-term view that corrects for short-term volatility,

The formula for the Shiller P/E ratio is simple: current price divided by average inflation-adjusted 10-year EPS.

To do that, you’ll need to find an index’s EPS for each of 10 years, adjust each for inflation to bring it into current dollars and find their average. You’ll then divide the index’s current price by this average.

Today’s market trades at a Shiller PE of 31x, above the levels it was at during both Black Tuesday and far above its levels during Black Monday. It’s also about 10% higher than its level during the 2008 crisis.

For comparison, the Shiller PE is now at about twice its median of 15.93x and almost twice its mean of 17.03x.

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