Market Sell-offs Are Not Necessarily A Bad Thing
(especially if you have a lot of cash)

January 21, 2022

US Monetary Policy aka the posture of the Federal Reserve which has the greatest impact on investment valuations will turn negative this year. Hence raising short term interest rates is causing the stock market to selloff in the near to intermediate term.

Adding fuel to the sell-off is the Empire Manufacturing Survey is signaling the economy will being slowing down.

While the short and intermediate term trend for stocks is negative. Going forward high quality stocks are declining in value that will eventually lead to a very good long term opportunity. So, while the main theme of my letter is negative for investments, long term this sell off will likely create excellent opportunities. Plus, having client account at approximately 80%+ in cash will allow us to take advantage of the opportunity when the time is appropriate.

The Fed’s objective is changing to fight inflation rather than prioritizing economic growth and employment. The consensus is for 4 rate hikes of .25% in 2022 and 4 more in 2023. A full 1% hike in short term rates is frequently associated with a short term 15% decline in stocks.

Due to the Fed’s new focus on raising short term interest rates, stocks have made a very hard pivot from Growth to Value. IMO, Growth and especially richly valued Tech stocks are in a Bear Market and untouchable for the time being. For example, the Ark Innovation ETF has fallen from $155 in February to $71 today.

This increases the odds of a market pullback to the 10%-20% range possibly in the first half of 2022 for the S&P 500. The Nasdaq Composite and especially richly valued Tech stocks could fall greater than 20%.

Aside from a special situation like ViacomCBS (which could be sold at +$60 per share this year to either Apple, Comcast, Amazon, Google) the Risk/Reward is unfavorable at the moment. But with stocks falling like lead weights they are progressively improving their risk/reward. More on the ViacomCBS situation below.

#1 The Growth Stock Bubble Has Burst: The anticipated end of the Growth stock bubble is at hand and not dissimilar to the bursting of the 2000 Growth stock mania. I have confidence in making this declaration because (just as was the case in 2000) the Federal Reserve is changing course which will have a significant impact on risk assets. They’ve created an enormously overvalued bond market where the “real” (real is interest paid minus inflation which is at 7%) is negative. 10-year Treasury yield was recently at 1.87%. 1.87% – 7% inflation = -5.13% real return.

The Fed and other Central Banks are in a “damned if they do and damned if they don’t” situation – a situation they’ve created themselves. They’ve created inflation which is not “transitory” in the short term and is compounded by supply chain issues and low unemployment-high wage growth (a major component of inflation). If they don’t raise rates inflation would likely run rampant which can lead to return of 1970’s style inflation. (I worked in a grocery store in the 70’s in charge of the coffee and cereal aisle. It was common to cross out old prices and add the new higher price more than just once a week)

Risk assets will decline – especially high growth related investments. This could include real estate but to a lesser degree. The increase in home demand and shortage in home construction make this a very tough call.

Raising interest rates are toxic to uber high valued Growth stocks since it increases the risk that future revenues and earnings will be reduced. Plus, using a Discounted Cash Flow model those high multiple earnings are not worth as much when risk free interest rises from 0% to 2.5%.

It’s conceivable that the broad based market indices could drop 20% or more this year. The cabal of Growth (Apple, Google, Microsoft, Netflix, Tesla) which have propped up the market since last February could face serious declines.

The valuation gap between Growth and Value is the highest since 2000. While the S&P 500 Growth index has a Price/Earnings ratio of 27, the P/E of Value is just 17. Last week Growth sustained the worst one-week loss relative to Value in 20 years. Bubbles burst quickly.

#2 The Pivot To Value: After the Growth stock bubble broke in 2000 there was a prolonged pivot to Value stocks that lasted for 7 years. However, Value stocks are still at risk in a sharp market pullback. They generally decline less than growth, so they are still at risk here.

Value stocks by and large are boring especially compared to Growth. But due to their inexpensive valuations they (in a broad perspective) are not nearly vulnerable to interest rates. Plus, according to Credit Suisse “S&P 500 Value is expected to deliver faster EPS growth than the Growth index (26% vs. 16%) in 4Q21 as well as in each quarter in 2022.”

Due to the 14 year dominance of Growth over Value, Value has a small footprint in the mutual funds popular today. Many mutual fund families offer no Value alternatives at all or have closed funds due to their lack of performance. It should be said that Value was not always a lagging investment style. The 1970’s and 80’s were dominated by Value especially during the mid 80’s take over frenzy of undervalued companies.

A key term in Value investing is the “Margin of Safety” concept. Hedge fund manager Seth Klarman wrote about the concept of “margin of safety” as it relates to investing years ago. It means that the current stock price is significantly below the tangible and intangible assets of the company. A stock that is so relatively inexpensive that its downside risk is likely limited. But, has an upside potential that is several multiples greater than the risk.

It’s very balance sheet oriented and frequently populated by companies where growth is subdued. There are no glamour stocks in the Value realm :). The Margin Of Safety (MOS) has nothing to do with short or intermediate term price movements. Its significance is in the long term.

A key investment rule I have is that when significant market sell-offs are finished the time is right to think longer term rather than short term. This means focus on quality at a reasonable price first. The farther we are away in time from a large sell-off the more shorter termed we’re focused on owning.

In November you could have bought Microsoft at $349 with the idea that “I’m a long term investor”. Well, now that its at $296 that seems pretty silly. But now, the sell-off has presented itself which changes our perspective to the long term.

The first selection in the high quality “Margin of Safety” realm is ViacomCBS.

ViacomCBS (VIAC) $32.5 a share with a 2.7% dividend with a viable chance for a sale of the company at over $60 per share.

VIAC is a premier media company with an extremely low valuation where the reward is potentially a multiple of the risk.

Viacom was built by Sumner Redstone who died in 2020 at age 97. His ownership was passed on to his daughter Shari Redstone. Viacom was once a dominant media company but in the last twenty years has been dwarfed by the group of Amazon, Apple, Comcast, Google and Netflix.

In March 2021 Archegos Capital was forced into liquidating their media holdings in ViacomCBS and Discovery. The sale was due to discovery of Archegos extreme and over-leveraged accounts. Shares were sold regardless of price and the shares of ViacomCBS which peaked at $99.99 fell to $36 within a month. The shares remained lethargic since then.

Shari Redstone is 68 years old and controls VIAC by her ownership of 79.5% of the class A shares. It’s likely she recognizes that critical mass (“size matters”) in the streaming business. Essentially, Viacom is a small fish in a very large and growing pond. While Viacom can earn close to $4 a per share share in each of the next 2 years long term growth is limited due to their inability to directly compete with the media Goliath’s. Current EPS estimates for ViacomCBS in 2022 is $3.90 a share.

What is changing the landscape for media companies is the increased present and future costs of Streaming media. A sale of VIAC to a company with abundant financial resources seems to be the odds on course for Ms. Redstone. While various measurements of the company show it might be worth as much as $75 per share using a sum of the parts valuation. A sale in the $60’s might be more likely.

The concept as it applies to VIAC is the valuation of the company at less than 9x earnings. A sum of the parts valuation that puts the potential value of VIAC to at least $60 per share and possibly $75. Much of the value is their legacy programming.

VIAC streaming business is growing faster than most of its competitors. They recorded almost $1 billion in streaming revenue with a 90% growth in subscribers.

Earnings are expected in the $4 to $5 range per years for the next three years which implies an extremely attractive valuation on earnings per share alone.

Insider buying? You bet. Shari Redstone and President/CEO Robert Bakish made large purchases in November and December at the $36 price range. Bakish has also publicly expressed his dismay at the current price per share.

While the odds are growing for a potential sale of the company the timing is impossible to anticipate. It’s possible that one morning we wake up to find a deal is complete. Therefore my intent is to hold the shares for a potential lengthy period of time.

If a sale does not occur, the forthcoming earnings in the next 3 years alone should generate a decent increase in share value.

“Deutsche Bank analyst Bryan Kraft upgraded ViacomCBS to Buy from Hold with a price target of $43 up from $39. The analyst believes Viacom offers “optionality” (meaning multiple ways to increase the share price). This includes valuation multiple rerating, greater success in streaming, and potential industry consolidation (a sale of the company) as Mega Cap Tech “sets its sights on becoming bigger streaming players”. Viacom’s enterprise value is a “fraction of that of the other four scaled content companies”. Yet, its annual content budget places it within range of the Mega Cap peer group. Kraft tells investors its his top pick in media.

From Dan Niles, Founder and portfolio manager of the Satori Fund, a tech focused hedge fund:

“I am an investor that likes stocks with growth at a reasonable price. VIAC trades at 8x CY22 PE despite their streaming revenues up 62% y/y. This is incredibly cheap compared to streaming leaders NFLX (46x PE; revs up 16% y/y in CQ3), DIS (~34x PE; streaming revs up 38% y/y in CQ3), and ROKU (~121x PE; revs up 51% y/y in CQ3.) These streaming leaders are all growing their streaming revenues slower than VIAC yet fetch much higher multiples. In addition to VIAC’s asymmetric growth vs. valuation profile, VIAC’s $1.1B in streaming revs in their September quarter grew to 16% of overall company revenues. NFLX is trading at 10x trailing sales. VIAC should do close to $5B in streaming revs this year, so it does not seem unreasonable to assume $50B is a reasonable valuation for this business alone. However, all of VIAC has a market cap of only $21B with ~$10B of net debt assuming current announced deals close.

From a subscriber perspective, NFLX had 214M subscribers at the end of Q3:2021 with a market cap of $267B. A valuation of ~$1,250 per subscriber. VIAC now has 47M streaming subscribers with 54M ad supported streaming subscribers from Pluto TV with a market cap of $21B. Just the value of the pure streaming subscribers for VIAC is $59B on this metric.

While we have admitted our mistake and cut our position in VIAC to take a tax loss for 2021, upcoming Q4 results and the outlook for streaming losses hopefully sets a bottom for the stock and sets the name up for a good rest of 2022. Investors may want to go to the sidelines until guidance is given on Q4 results or sentiment reverses for the company.”

Summary: We will continue to hold very high levels of cash until stability returns to the markets. The rate of decline in superlative stocks such as Apple and especially Microsoft make them attractive for long term holdings.

My focus is to use this selloff to focus on Quality above all else.

ViacomCBS is a wild card. Despite the potential for short term volatility (such as todays fallout from Netflix) the long term is very promising with the potential for a sale this year. ViacomCBS is a special situation and it will remain the only “special” holding we own.

Eventually this selloff will end. Preservation of capital and patience should be prioritized for the time being.

Thank You for reading,

Brad Pappas

December 2, 2021

For a period of the year that stocks are supposed to be very strong they’ve put in their worst performance during Thanksgiving week since the 1940’s.

The continual erosion in the % of stocks above their respective moving averages is potentially coming to crescendo conclusion. A healthy market is a market that lifts all boats and not just a handful.

The three biggest props to the market have been Apple, Google and Microsoft. For example, yesterday December 1st Apple traded from 165 to 170 in the morning. (I sold at $170) on a day in which the Nasdaq rose from 15560 to 15814. Once Apple peaked at $170.27 it fell to $164.70 and the Nasdaq fell from 15814 to 15208 or 3.8%! And, all in a single day.

In the chart above the second row shows the Number of Nasdaq Stocks Making New Highs minus the Number of Nasdaq Stocks Making New Lows. It reveals the present market weakness is the most significant since the Covid low of 2020.

It also shows that the percentage of stocks above or rising above the 50-150 and 200 day moving averages is almost in free-fall. Eventually the major market indices will reflect the serious erosion in the average stock. So it’s my opinion that we are not near the end of this decline. Every rally at this point is an opportunity to sell.

With risk so high and a market bottom no where in sight we are at 100% cash. If the selling becomes severe enough we will have an opportunity to truly invest and not be a short term owner. Or, as an acquaintance says “You’ll have the opportunity to marry some stocks rather than just dating.” Looking at my data this selloff has at least another two weeks before some semblance of stability is restored.

Serious market weakness is a significant opportunity. In an average year there are usually only about 2 windows of market weakness that offer such an opportunity. Due to the Federal Reserve’s support of bond prices stock sell-offs have been only very brief and shallow.

In the meantime, the best thing to do is sit tight. It doesn’t matter in the end what the cause of the selling is. There is always another good market rally to emerge after serious selling and that’s what we should be focused on. And, having 100% cash will allow us to be unemotional despite what the near future has for the markets.

Thank You,

Brad Pappas

PS: Over the past year of two I’ve told many of you that Janene and I were going to move to the Ft. Lauderdale area. We’ve thrown that plan out the window and have settled on moving to Downtown Denver. The fire risk here is too much. Just last week I spotted a nascent brush fire just a quarter mile from our home.

September 29, 2021

We are potentially arriving at a point where a good risk/reward entry point for stocks may present itself. There has been a frustrating lack of entry opportunities for equities this year. However the concerns regarding the Fed’s future change of course appears to be having the desired affect of stomping out excessive enthusiasm.

Fear is almost always present at market lows. Or, as long time market technician Walter Deemer used to say: “When it’s time to buy you won’t want to. When it’s time to sell you won’t want to.”

As much as I loathed the sell off for the past two days, it has created driven down the markets to the point where it’s time to think about adding to our holdings. At present we are in the weakest portion of the year for stocks. This will give way in approximately two weeks to the strongest seasonal tendency from October thru March.

It’s too early to do any serious buying today and possibly next week. I’ll continue to wait until buy signals appears before moving aggressively.

Changes to the stock selection and holding process

Markets are always in a state of evolution in trends. What worked in years past will likely not work in the future and visa versa. For most of my career in portfolio management I’ve changed strategies to fit and improve performance going forward.

It has been a difficult year for RMHI as it has been for the vast majority of technical trend traders. 2021 has been a year where a “buy and hold” approach worked well but only for a tiny majority of stocks. I’d place these stocks and their inherent characteristics in what I’d call “Stable Growth Leaders” or SGL.

The most common characteristic of SGL’s is their consistent moderately high earnings and sales growth. In addition, this category of stocks must also maintain performance greater than the market indices for a multiple of years.

I scan my screens daily for SGL’s but on any given day there might only be 10 to 15 that meet my parameters.

My strategy is to have at least 50% of account assets in these names, many of which are already in your accounts now. These are not intended to be traded actively unless they drop or rise precipitously, like Adobe Systems did recently.

Presently, the following meet my criteria and are in client portfolios today. So you know we only have partial positions in accounts right now. I’ll add to them should the market stabilize and begin to rally:

Entegris
Epam Systems Fortinet
Ihs Market Ltd Intuit
Johnson Controls SVB Financial Group

Current market weakness creates and ideal entry point for these kinds of stocks. While I’ve only listed 7 names, several more companies have fallen back in their buy zones.

With the exception of SVB Financial which is in the black for us. The other holdings have moderate to small losses. Thats ok for now. These names have repeatedly bounced back from sell-offs in years past before resuming moderate and steady appreciation.

The balance of our holdings will be the classic technical trading that works very well in strong markets.

In creating this form of hybrid methodology is an effort to create more balance where at least one strategy could be working while the other does not.

In addition, both technical and SGL’s will work initially after a good market sell off like we’re in the midst of right now.

Thank You,

Brad Pappas

September 21, 2021

For months I’ve been writing and saying that the major market indices have been masking the erosion of individual stock declines. When we see this type of erosion with underlying stocks it usually means there is a broad selloff coming.

What made the erosion unique in 2021 has been how long it’s been sustained. The percent of stocks above their respective 200 day moving average peaked in April 2021 and has been declining ever since. I believe this is the longest streak since 2000.

Unless you’e a day trader it’s very difficult to show sustainable profits when the tide is moving out.The erosion accelerated in July to the point where the indices have finally given way.

This should be considered a pullback within an ongoing long term bull market and not the start of something more severe.

As always there are a lot worries out there:

The Republican stance of not raising the debt limit is phony and the limit will be increased.

The Chinese governments attempt to control the Evergrande debt fiasco poses risks for the Chinese economy which is the driver of world economic growth.

Chmn. Powell’s testimony tomorrow will likely be mild. He has enough issues on his plate to cover his dovish stance for quite a while longer.

I previously showed the chart below this Summer with the understanding that going into the weakest months of the year. Correspondingly once we emerge from early October we’ll be entering the strongest months of the year.

Covid luddites prolonging the pandemic.

In my opinion the market weakness is a buying opportunity once the markets stabilize. The chart says late September or early October.

Plus, Monetary policy remains easy which is conducive to a bull market.

Summary: This appears to be a garden variety market selloff and not the start of something more significant. Monetary policy in the US would have to severely change in order for a prolonged bear market to emerge. This is not the case today.

My hope is that this selloff puts and end to the waning individual stock participation – it usually does. And, in doing so creates enough fear and angst for a new leg higher for stocks and the indices.

Sincerely,

Brad Pappas

August 9, 2021

Imagine watching a long bridge over water filled with traffic. The bridge appears stable and strong with no sign of weakness on the roadbed. But if you look below to the bridge foundation you see individual bits of brick, mortar and concrete fall into the water.

The bridge road surface is still stable but for how long? And, would you be willing to cross it?

This is my attempt at an analogy of the broad market indices today. Markets are stagnant but stable on the surface. However severe erosion exists beneath the surface which has made investing increasingly difficult. Trades that normally would hold value after a few days are reversing after days 2-4.

For example, the Nasdaq 100 made a new all-time high today (8/5) but only one stock from the index made a new high as well: Costco.

In this letter I show how there have been several periods like this in the past. While its not 100% assurance that a good sized sell-off ensues, its a high probability occurance. Periods like today with eroding stock participation are before sell-offs in excess of 5%-10%+.

From my observational view when I run into trouble buying into a series of high probability trades that end up not working out, I stop. By stopping I want to see why my textbook entries are not working out as they should in a healthy market. Recently there have been a few textbook trades that are strong on day1 but run into trouble after day 2 or 3. Whats happening?

What is happening is that big institutional firms are selling into the rallies rather than making additional buys that can propel the stock higher. We’ve had cases where this has not happened such as with Adobe, Align Tech or Cloudfare. But we’ve taken enough small losses to force me to pause.

Bob Farrell is Old School. He was the Chief of Technical Analysis at Merrill Lynch when I first broke into the business in the early 80’s. In his Ten Lessons of Investing is the following quote:

“Markets are strongest when they are broad based and weakest when they narrow to a handful of blue-chip names.” And that describes exactly where we are in August 2021.

Since July, equity markets have become a chop-fest. Up, down, up, down with zero consistency while the percentage of stocks above important moving averages continues to decline.

This erosion in the markets is being masked by the largest % weightings in the S&P 500 index. The S&P 500 is not a group of 500 companies weighted equally so it’s possible to prop up an index with heavy buying of the highest weighted stocks.

Apple 5.5%
Microsoft 5.3%
Google aka Alphabet A & C shares 4%
Amazon 3.9%
Facebook 2.2%

At the moment we are time period where companies are reporting earnings and expectations for the second half of the year. And, there is a trend emerging in which Amazon, UPS, Facebook, Apple are reporting that the first half of the year revenue growth was unsustainably great that it was borrowing from the second half of the year. In other words, all 4 companies that benefited from the Covid crisis are expecting declines in demand and revenues for the second half of the year.

In addition, we can expect the Fed to begin easing off their purchases of Treasuries and Mortgage backed securities – as if the real estate market isn’t hot enough.

These are my thoughts as to why we could experience a sharp down move in stocks in the coming two months – August and September happen to be two of of the worst months for stocks. But at this point these are opinions that have yet to be validated by the markets.

Based on the chart below, the cycle peak for stocks was last week. Maybe its accurate, maybe not. It’s interesting regardless.

Now lets drill down to facts:

The Nasdaq composite remains elevated but without serious weakness at the surface. This is due to the pegging of Google, Apple, Microsoft, etc expressed previously.

Below the surface to individual stocks there is a very different story. Serious erosion in the average stock while the indices remain high. As the chart shows this is not a rare occurrence but it usually leads eventually to significant market weakness.

The percent of stocks below their respective 150 and 200 day moving averages (dma) continues to grow. The Bob Farrell quote comes to mind here.

What is happening is that investors are cutting their losses in stocks and then shifting the assets to FANG + M (Facebook, Apple, Netflix, Google and Microsoft). In a sense they’re hiding in extremely large and liquid shares.

If there is a serious market decline those who’re buying FANG + M will sell those as well.

Another method of analyzing the erosion in participation (market breadth) is the Nasdaq McClellan Summation Index (NASI) which has clearly been on a Sell recommendation since July.

Every major market pullback in the last 20 years show declining market breadth before the bulk of the selling began. However, not every period of declining breath presaged a sizable market pullback.

Should market breadth begin to improve, I plan on increasing our percentage invested. In the meantime its very difficult to sustain meaningful gains with the current erosion in stock participation.

Like everything else market-wise this is a temporary condition. Its just not an ideal time to be aggressive and fully-invested.

Thank you for reading.
Brad Pappas
August 9, 2021