Does this rally have legs?

November 9th and 10th 2022

The last decade will be known as the Decade of the Big Tech Growth Stocks. A temporary period where investors deluded themselves into thinking the only stocks worth owning were shares in Technology: Amazon, Apple, Facebook, Microsoft, Google. These stocks represented approximately 23% of the S&P 500 Index.

This is not the first time its happened since human psychology tends to repeat itself. In the 1970’s there was the “Nifty Fifty” and you’re going to have to be of a certain age to remember these names. (Remember people thought they could buy these stocks and hold them forever. Many don’t exist anymore.)

Digital Equipment: financial problems forced a merger into Hewlett Packard.
Eastman Kodak: Bankruptcy
Emery Airfreight: Sold to Consolidated Freight after failed hostile takeover.
General Electric: 2011 forced into restructure after profitability collapsed.
Heublein: Sold to RJR Reynolds Tobacco which sold off Heublein’s assets.
JC Penny: May 2020 Chapter 11
Poloroid: 2008 Bankruptcy
Sears, Roebuck and Company: October 2018 Bankruptcy
Simplicity Pattern: 1998 sold to Conso International
S.S. Kresge: Renamed Kmart in 1977. By 2005 was part of Sears.
Upjohn: Acquired by Pfizer.

Just 22 years ago another generation of must-own stocks represented 18% of the S&P 500.

Microsoft
Cisco
Exxon
Mobil
General Electric
Intel

In this group only Microsoft and Exxon were able to maintain relevance. While Cisco remains a viable company the stock has yet to exceed its year 2000 high. 22 years is a very long time for dead money.

As for 2023 investors should expect no different.

The point I’m trying to make is that is common for investors to look at past favorites in the hope they’ll be future top performers. But it’s a very flawed strategy in real time. If you remember my letters from last year a high percentage of money was flowing primarily into Big Tech. Now the reverse is happening. The migration of capital out of Big Tech continues and that money is moving to the Russell 2000 Index composed of smaller company stocks which underperformed while Big Tech was dominating for the past decade.

If I were to guess I would say that we’re in the 7th inning of this Bear Market.

A short term Buy signal for stocks. (But not Big Tech)

MACD short term buy signal (Moving Average Convergence Divergence). Created by Gerald Appel in the 1970’s which shows changes in direction, momentum and strength of a stock or a market index. Longer term signals remain “out of the stock market”. But, short term signals are always the first to turn negative or positive.

New market leadership and a new trend will emerge as it always does. If a new Bull Market for stocks was to begin the stocks of smaller companies might be where it begins.

The chart below shows how the small stock Russell 2000 is outperforming the QQQ (proxy for Big Tech) when the line rises it indicates outperforming the QQQ. If investing was ever easy the leaders of the last bull run would repeat in the new one. Simple idea but its wrong.

Last month was extremely negative and investor sentiment was awful. This generally bodes will in the near term future results and at least a short term rally has occurred. I’m playing it very conservative with companies that are non- cyclical or not very sensitive to the economy.

We are only invested minimally in the strongest sectors and industries, primarily healthcare and insurance. Every stock we own has done well this year on an absolute and relative basis. I no desire to try to catch falling daggers aka tech stocks.

Update November 10, 2022

This mornings CPI inflation data came in below expectations as the year to year came in at 7.7% versus a forecast of 7.9%. The market exploded to the upside on this news with the Dow exceeding 800 points in less than a minute.

Fed chair Powell has said he’ll be watching the data closely as a signal for when they can minimize interest rate hikes. Markets are possibly pricing in an end to the hikes earlier than expected. If todays data is the start of a trend to lower inflation it would be a positive for both stocks and bonds. Longer term the Fed can move to a more accommodative policy in 2023.

Much of the biggest movers today to the upside are beaten down past leaders that are still in strong downtrends.

There is no need to chase stocks or bonds higher at present. If this rally has legs there will be ample opportunity to rebuild portfolios for a new Bull run.

Thank you for reading

Brad Pappas

September 6, 2022

Both stocks and bonds have declined since my last note to you from August 26. The Fed must correct the excesses created by the Fed during the Covid crisis. The official US response was $9.5 trillion of stimulus ($5tn fiscal and 4.5tn monetary stimulus). This amounted to 38% of GDP.

To put some perspective on how excessive the Fed was: During the financial crisis of 2008 the total fiscal stimulus was 5.7% of GDP (source St. Louis Fed) and monetary stimulus was 9% of GDP (Source Fed balance sheet). Added together there was a total of 14.7% of fiscal and monetary stimulus relative to GDP. And according to Brian Belkin there was no exit plan.

So, total Covid stimulus was 2.6 times larger than the 2008 credit crisis. I’m not even going to add stimulus data from the European ECB and other entities.

As the chart above shows given the excesses of past years its possible there is much more downside risk than investors are expecting. The 200-month moving average which is at 2250 could be reached. Thats another 40% down since at present the S&P 500 is at 3900.

Plus, Treasury bonds which have been very unforgiving have already pulled back and gone below their 200 month moving average.

So thats where we are, doing nothing and remaining patient. I still believe there is a moving coming in Treasury bonds but I have no idea where or when it will begin. My guess is that for bonds to move higher it will take another gruesome decline in stocks.

Thank you for reading
Brad Pappas

Driving Forward Thru The Rear Window
August 2022

The recent stock market rally over the last month garnered most of the attention from investors. The idea that just because the Treasury bond market has stabilized its now time to buy Growth Stocks is foolish. Buying due to lower rates works when the Fed has your back but its lethal when they’re not. This is typical of investors who don’t know any better and desperately need Fed stimulus to push stocks higher. The problem is the Fed is now doing the opposite with restrictive policies that are toxic to stocks but ideal for Treasury bonds (T-Bonds).

Earnings for these Growth stock giants are down 10.1% sequentially. Earnings are declining and thats what we would expect in a recession.

Nvidia could be added to the list. The semiconductor giant reporting Q2 revenue $6.7B versus estimate of $8.12B.

The Federal Reserve is fully focused lagging indicators like the Consumer Price Index and employment. The CPI is a reflection of past data and it takes 6-9 months for the rate hikes to have their effect on the economy. So the Fed can easily overshoot their objective of reducing the CPI. This also means they’ll place the country into recession (assuming we’re not in recession).

Since the data of the US going into recession is increasing prices for long term maturity Treasury bonds are rising. Even though the Fed will be raising short term rates, longer term rates are controlled by the open market. Yields are falling because present policies will cause a recession which will force the Fed to lower interest rates in 2023.

T-bond markets are forward thinking while the Fed is monitoring rear view data.

This is the most important chart I can show you. When the yield on the 10-year Treasury bond moves below the 2-year Treasury bond its called “Yield Curve Inversion” or YCI. YCI has a great history of being a forward indictor of rising unemployment, recessions and falling stock prices. The YCI has correctly anticipated every recession for the past 50 years.

When the Yield Curve inverts it’s a signal that interest rates will stop rising and T- bond prices will rise. This is why our highest asset allocation is to Treasury Bonds.

Recently RMHI became a client of Michael Belkin of the Belkin Report. Belkin created his proprietary forecasting model at UC Berkeley and further refined it as an analyst at Salomon Brothers. His institutional clients manage just under $2 trillion. From my perspective he is one of the best.

Based on his modeling:

1. Treasury bonds have exited their bear market which stocks have only just entered.

2. Recession “Our model forecast continues to point straight down for real GDP growth and corporate earnings, which are ultimately the determinants of stock prices. The forecast suggests the recession is just starting and will continue for 12-18 months. Sell stocks, buy government bonds.”
3. The current bear market in stocks is only about 1/3 finished. Nasdaq could fall 60% from the November 21 peak. The S&P 500 could fall 50%.
4. How best to position oneself for the near term future? Exactly what we are presently doing. A. Own Treasury bonds. Belkin expects the “TLT” Shares 20-30 year Treasury bond ETF to rise 15% to 20%.
5. When stock markets make temporary bounces higher add our 1x shorts (that benefit from falling stock prices) “SH” “RWM” and “PSQ”.
6. “Market psychology currently equates lower government bond yields with stock market optimism, especially for tech stocks….We disagree. Thats now how it works in a recession. Go back and look at 2000-2002 or late 2007 to early 2009. Tech stocks and the market got creamed while T-bonds rallied because the economy and S&P earnings collapsed. That is probably wha we’re setting up for again. Sell stocks and shift into government bonds.”

Belkin notes that there will be a shift in investor psychology away from stocks to T-bonds based on fear of a falling stock market. (This always happens in major bear markets. Investors give up hope in stocks and gravitate to the safety of T- bonds. As a result when the stock market eventually bottoms they’re too scared to return to stock and wait till the rally has already moved a great deal.)

As Stanley Druckenmiller has said: “Never, ever invest in the present……You have to visualize the situation 18 months from now, and whatever that is, that’s where the price will be, not where it is today.”

Thank you for reading
Brad Pappas
August 9, 2022