Optimism for 2022?

It was great catching with my friend Nathaniel Baker on his contrarian podcast discussing markets and why I am optimistic for 2022. Check out the link below for our 30 minute discussion. 

https://contrarianpod.com/content/podcasts/season3/causes-for-optimism-in-2022-ryan-worch/

Is the Fed going to burst the bubble?

At some point this market will have a bear market and very well could coincide with a rising rate environment. Trying to time or predict when it will happen is fool's gold. What we do know from market history is that pullbacks, corrections, and bear markets are a normal part of investing. A pullback is defined as a decline of 5% to 9.9% and occurs on average 2.5 times a year. Corrections (10% to 19.9% selloffs) happen every one and half years and a bear market (>20% loss) nearly every three years. A study from JP Morgan says the average intra-year drawdown in the S&P 500 is 14.3%.

 

A good example is 2021 which has been in a sustained bull market. The S&P 500 has experienced two pullbacks in 2021 while maintaining a strong uptrend. Meanwhile, the Nasdaq has been through four such pullbacks this year in what has been characterized as a volatile climate for growth stocks. Trying to rationalize every wiggle in the market is another futile exercise. Regardless of how you calculate the data, selloffs happen and happen more often that thought for various reasons. 

The latest excuse for market weakness: Fed's tapering of liquidity, Omicron variant, debt ceiling, etc. Yet if look back at history to the last taper tantrum in May of 2013 the S&P sold off 5.8% in the next month but rallied 17.5% for the rest of the year. According to Sam Stovall at CFRA Research, "After a very minor pullback known as the 'taper tantrum' stocks took off. Above average market returns across all styles, sectors and up to 80% of all sub-industries. That goes for not only the market rebound after the "tantrum" but the 10-month period that included the actual Fed tapering activity. In the 10-month tapering period, from mid-December 2013 to the end of October 2014, the S&P 500 rose 11.5%, according to CFRA Research. The likely reasoning, Stovall says, is that investors concluded if the economy was strong enough to withstand the removal of supportive bond-buying activity, it was healthy enough to continue to expand on its own."

At Worch Capital, we believe the eventual bear market will be brought on by a move in interest rates or an unpredictable market event outside of the normal business cycle. If history is any guide we should be due for one around the summer of 2022. These numbers are based on averages and can vary wildly. For reference, the longest bull market lasted almost 8 years, so anything is possible. So with all the recent doom and gloom I wanted to look at some data that shows some potentially bullish signals going forward.

While the Federal finances are a mess, consumers are showing an extremely healthy balance sheet as total assets are hitting new highs while personal liabilities are making new lows. 

 

Charlie Bilello had a recent tweet showing the VIX had the 4th largest one day % increase in its history as it rose 54% on 11/26/21. His key takeaway: "the market tends to rise over time and tends to rise more following volatility spikes (note: on average, there are always exceptions and this latest spike could very well be one).

 

His data shows the S&P has been higher one year later every single time the VIX has spiked 40% or more. Our own data confirms this, but has one negative period one year later which was in 2007. Below is data on the Nasdaq's performance after a VIX spike of 40% or more. 

 Between the two studies the S&P and Nasdaq average 20%+ returns a year later after a VIX spike.
  

Another study by Ryan Detrick at LPL Research shows "that when stocks are up more than 20% for the year heading into December (like 2021), the final month actually does better, up 1.7% versus 1.5%. Also, it has been higher eight of the past nine times the year was up more than 20% heading into the final month.

 

One area that we monitor that is worrisome is the massive divergence in breadth. These divergences can last months and sometimes years and most of the time they reverse themselves. But when you get a hard break in the markets accompanied by weak breadth that is usually a time to play more defense than offense. For now the market indices have maintained their up-trends. The weak breath proves how narrow this market remains with a handle of mega caps holding up the indices. Underneath the surface many stocks are well off their 52-week highs. Unless this current turbulence turns into the next bear market (ie: 2018 and 2020) the current weakness is getting very close to oversold levels and where the market has usually found buyers. Below is the % of stocks trading above their 50 day moving average on the Nasdaq. The yellow lines show areas where the market found a low and started to bounce. 

At the end of the day price pays. But the data above gives some comfort to the bulls. It is never easy and sometimes very messy but focusing on fear mongering is not a good strategy. There are always things to worry about in investing. We try and parse the data and come up with a thesis. Yet, when price diverges from that thesis we adjust accordingly.
 

 

 

 

 

Does history repeat?

At Worch Capital we are big believers in pattern recognition. The famous quote from Mark Twain that history does not repeat itself but it does rhyme is very appropriate in trading the markets. As a student of markets we look for historical precedent to shape our thesis. We then let Mr. Market decide if we are right or wrong as price pays at the end of the day. We are also not big believers in making predictions as most are useless and wrong. Sure, you can eventually be right on a market call but if your timing is way off you can go broke trying to prove your viewpoint. As we embarked on our weekend research I wanted to look at the current pullback and compare it to prior pullbacks to see if I can discern any similar patterns. I came away still convinced we remain in a secular bull based on the weight of evidence presented in the major indices we track and follow. We look at short(20day), intermediate(50), and long term(200) trend-lines to identify where the markets are in their current position. The SPY, QQQ, and IWM remain in strong long term uptrends as their 40 week (blue line) moving average (200day on daily chart) are all pointing higher. The intermediate trend (red line) is starting to weaken and roll over as the 10 week (50 day on daily) is starting to move lower after months of making new highs. The IWM remains in a massive sideways consolidation and a break of the the upper or lower channel will most likely determine the next move.

 

There is also plenty of evidence that shows the strong move from the beginning of the year will continue. Even though we had a tough September and broke a streak of 7 straight up months there remains some strong data that suggests the uptrend will live on. Below are two studies that back this up. 

Ryan Detrick's recent tweet shows how the S&P was up 6 quarters in a row. The next quarter has been lower only once and incredibly, two quarters later, stocks have never been lower. The average move a year later is +15.5% and yet another clue we are in a secular bull market and the surprise will be to the upside. 

The tweet from Steve Deppe shows how a weak September from a new all time high actually leads to strong returns.

Now as growth investors we are more concerned with that sector and momentum than other areas. But the data above confirms our bias that we remain in a secular bull. However, all is not rosy and the charts below have dampened our enthusiasm. We have been using the Ark funds as a proxy for the high growth and speculative areas of the market. They had a massive run the last few years and reminiscent of the late nineties. When an asset class has massive out-performance we are always aware of the potential for a hard snap back. So we started studying prior moves of excess and the following collapse. Low and behold from a pattern perspective the current set up in the ARKK ETF is very similar to the Nasdaq in 2000. After a massive up move in 2020, ARKK has underwhelmed so far in 2021. A big sell off from the peak in February has left it in a downtrend with all of the major moving averages turning lower. Does the next move set up a second leg down like 2000 or is it set for a bounce? I don't know the answer but the similarities in patterns and timing is enough to pique our interest and something we'll be following. 

Nasdaq March 2000:

 

Tech collapse and subsequent bear market:

As growth has struggle since mid February we have been hesitant to put too much risk capital to work and be aggressive. We remain cautious and neutral and are willing to be patient waiting for the next opportunity to present itself. Until then we'll continue to monitor conditions and adjust accordingly.

Second Half 2021

 

Considering the strong returns in the first half of 2021, we will provide our thoughts on the second half. Obviously, we cannot predict the markets; however, we can use some statistical analysis to shape a thesis and probabilities. Usually, market strength begets strength and most of the studies confirm this. That is bullish for the second half of the year. We will look at two studies: one that confirms that bias and one that differs. For a bullish tone, a study by one of our favorites, Ryan Detrick, shows that when the S&P 500 is up greater than 12.5% year to date at the end of June, the next six months are up a median of 9.7% which is twice the median final six months for all years.

 

If we want to pump the breaks on optimism, we know that the third quarter is the most challenging during the year with August and September being some of the worst trading months. A recent study from Nautilus Capital provides a contrast to the recent strong upside momentum presented above, writing “#SP500 first half year to date momentum "IS" typically a good indication of continuing rest of year momentum (no revelation there as many technicians; including us monitor this closely.) In contrast, the study below offers an interesting "twist" on potentially excess momentum....”   

This study certainly paints a different picture than the normal strength begets strength argument. Another study shows the one-year rolling correlation of the Nasdaq 100 against the ten-year treasury yield. This is simply another valuation metric that shows that the index is historically extended. The question is whether the future is based on the 2000 and 2007 precedent or more like the mid-90s and 2017-time frame. Clearly the outcomes are incredibly different with the former leading to devastating bear markets and the later just a continuation of a secular bull market.

 

 

As we look to the second half, the most important consideration from a macro stance will be the direction of interest rates and yields. The language from the Fed will determine most of that action and their decision to taper, raise rates, or do nothing will be the most important discussion. Every statement or comment will be combed through in fine detail looking for the smallest of nuances. Yet, after a tough first half for growth equities, we could see a sustained rotation out of value and back into growth if rates subside. A recent tweet from Jurrien Timmer sums this up, “with peak reopening and peak inflation likely behind us, I expect some ongoing counter rotation from growth stocks.”

We expect the inflation debate will continue in the back half of the year. Additionally, there will be ruminations about the pace of economic growth, which is certain to decelerate from the torrid pace seen in the first half of the year. The Fed will be central as they attempt to shift policy and dance around concerns over peak growth, Delta variant, and inflation.

We still believe the market remains in a secular bull market and the future remains very bright for growth equities as the technological revolution continues even after a tough first half. As active managers, our smaller size allows us the flexibility to change our exposure levels with more ease, which is critical for extracting alpha for our partners. We believe our methodology protects our partners’ capital through various cycles.

What to do when out of sync with market?

After a banner year last year for growth and momentum, 2021 has been a historically frustrating year. With the S&P up double digits again YTD it is surprising that certain sectors are drastically underperforming. So what do you when your strategy is out of favor while the general market doesn't show any signs of weakness? If you invest long enough all investors and managers will go through difficult periods. The key is to know your strategy in and out and know when it is time to be aggressive and when it is time to be more risk adverse and selective. If we take a quick look at some data and statistics we can get a better idea of what is being rewarding in this environment.  

Lets take a top down approach and look at which asset class is leading. We can see that commodities are in the lead as bonds lag drastically. 

 Commodities have been on fire.

If you want a reason for why commodities are surging we can look at the recent March PPI prices:

• Plywood (construction): +53 percent vs. last year
• Cold rolled steel (durable goods): +75 pct
• Copper (construction, durable goods): +43 pct
• Corn (food, animal feed): +44 pct
• Wheat (food): +32 pct

One of the big surprises of the first quarter was the historic rise in interest rates. The 10-year treasury note started the year around 90 basis points roughly doubling to 175 basis points. Albeit from a very low starting point, the 10-year yield put in the biggest 40-week rise in rates, by a long shot, going back 50 years. Below shows how dramatic the rise in yields has been YTD across duration's.

 

The increase in yields put the biggest pressure on high valuation growth stocks. Many growth stocks are in bear market territory even with the general market positive on the year. This bifurcation is the exact opposite of what worked last year. Toni Sacconaghi, a longtime technology analyst at Bernstein, encapsulated the dynamic in a fascinating piece of research. “He points out that, in 2020, investors seemed to be buying techs almost because of their high price tags. In fact, if you divide the tech universe into quintiles ranked by price/earnings ratios, the returns were lowest for stocks with the lowest valuations—and highest for those trading at the loftiest multiples. The average tech issue outpaced the broad market by 28 percentage points last year, but those in the top quintile outperformed by 60 percentage points. Writes Sacconaghi: The more expensive a stock was in 2020, the better it generally fared. But investor behavior is shifting. Tech shares have underperformed the broad market by about four percentage points this year, according to Sacconaghi. The most expensive names are running 10 points behind and the stocks at the other end of the valuation spectrum—the cheapies—have beaten the market by about 6%. In short, what went up is indeed starting to come down, he writes.”

The correction in high quality growth names will set up future opportunities, as YTD is a tale of two tapes and the opposite of last year. There was a huge rotation out of growth and into value, small caps, and the reopening theme. Below is a good representation of the shift out of growth and into value. It is a ratio chart of the VUG (Vanguard Growth ETF) to the VTV (Vanguard Value ETF). When it is rising, growth is outperforming which we see with the historic rise last year. This trend started to stall out in the fourth quarter of last year and broke down in the first quarter of this year as money rotated away from high growth and into more value centric ideas. It now has the look of a big head and shoulders top with a retest failure.

When we drill down to market capitalization we can clearly see smaller caps are outpacing large caps. 

Lastly is a list of sector returns year to date. When beaten down energy and financials are leading the market that is not a ripe environment for growth. The current market clearly favors cyclicals and commodities. 

Now that we have an idea what is working and what isn't we can look at a few data points that gives some future potential. A few studies from Ryan Detrick show conflicting possibilities. Even though we are entering the worst 6-month stretch of the year, based on some recent data the future looks brighter. 

 

A second tweet from Ryan Detrick shows how this current bull trend could be getting close to exhausting itself in the short term. 

As we enter the sell in May and go away theme for the next six months, one data point helps back up this case. A recent note from DataTrek research shows "the latest Investment Company Institute money flow data for long term mutual/exchange traded fund flows paints a less optimistic picture. We now have data through April 28th (essentially month end); here’s how it looks:

• Fund investors redeemed $17.8 bn from US equity funds in the final week of April, enough to flip whole-month flows negative to the tune of -$7.8 bn.

• There were also $4.6 billion in non-US equity fund redemptions, but April’s total is still positive by $17.6 bn.

• Fixed income fund flows, by contrast, were strong last week (+$19.2 bn) and April as a whole looks like inflows will total $76.2 bn. That’s the best month for this asset class since January’s $93.8 bn of inflows.

• Commodity fund (mostly physical gold) inflows last week were slightly positive (+$119 mn) but April’s outflows still total $1 bn.

Takeaway: it’s just one week of data, but the sudden and sizable reversal in US equity fund flows after 2 solid months of inflows isn’t something we can just dismiss, especially given the money market fund data. Perhaps investors are starting to sell positions with large capital gains (those would more commonly be in US vs. non-US equities) now that the current Administration’s tax plan is out. Perhaps stimulus money going into US equity funds has run its course. Perhaps late April’s sales were just rebalancing. Perhaps it’s all of the above. One thing is for sure: it will be much easier for US equities to continue their rally if flows turn positive again. We’ll know soon enough."

The question is what do we do when our strategy is out of favor. I have been in the business long enough to know that styles ebb and flow with market cycles. Not one strategy dominates every market year in and year out. Where most amateur investors fail is they get complacent and chase the next hottest investment product. However, if you know your methodology and trust the process you have confidence that opportunities will eventually present themselves. Sometimes the best trade is to do nothing while the hardest trade is to keep powder dry while reducing risk sitting patiently for asymmetrical bets to turn up.

A quote from Dr. Brett Steenbarger sums up how a trader should react under uncertainty, "that is where meditation and self-control techniques learned through biofeedback can be very helpful. If market volatility has picked up, there will be plenty of movement to participate in. The key is standing back, slowing yourself down, consulting the data and then looking for opportunity. Because the volume and volatility are coming from large participants in the marketplace, their behavior can create significant directional opportunity. You just want to be at your mindful best at those times so that you size positions properly and don’t let the excitement lead to overtrading. A lot of money can be lost quickly under chaotic conditions."