Where are the big guns aiming, and should we follow them?
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Good is bad
It was yet another choppy week for financial markets, with uncertainty rife at present. There was a short-lived rally across risky asset classes to begin the week before the markets pulled back following the release of non-farm payrolls, which beat expectations. Non-farm payroll is a figure released on the first Friday of each month, showing the total number of jobs added in the US economy during that month. The strong beat shows the economy is growing and remains robust following the Omicron variant restrictions. In addition, average hourly earnings (average hourly worker wage) rose 5.7% year over year, above an expected 5.2% increase.
In short, strong employment data is negative for markets, as it means that the Federal Reserve will have to continue on its path toward restrictive policy (raising interest rates and quantitative tightening). These figures led to a rise in yields and the US Dollar, and a fall in equities. The Bond market puke (yields rising means prices falling i.e. investors selling) is accelerating the risky asset sell-off. Insurance (in the form of credit default swaps) is the highest since March 2020. However, there is no sign of panic selling as of yet, but a new low in the Nasdaq 100 or S&P 500 could quickly lead to such a scenario. The chart below shows the Nasdaq 100, an index of the 100 biggest technology companies listed on the US stock market. It has reached new lows and is now below its 200-day moving average (orange line). When a stock or index falls below this, many investors interpret it as a signal that a new downtrend has begun. Many investors also use it as an indication that it is time to sell. If the Nasdaq makes a new low (below 14000) next week, there could be a continued sell-off across the stock market, and if not, we may be near a bottom.
Nasdaq 100, Source: TradingView
Outlook
As I predicted in December, due to the hawkish shift of central banks there has been a large rotation out of these highly-valued technology and growth stocks into value stocks such as banks and commodities, which have held up well in the recent market drop. I noticed that this week all of the biggest 1-year risers in US markets are now oil and commodity miners, compared to six months ago when this table was filled with high-growth stocks such as Tesla. The rotation has occurred.
We seem to be at a crossroads today. Bond yields are rising (suggesting a strengthening economy) and inflation is high but it is no longer rising rapidly. Over the coming months, I feel we will move between a reflationary (value) and growth environment, depending on whether inflation starts to fall or not. Many speculative growth stocks have cratered, and there are now several attractive opportunities in this space. I am allocating 1% of capital to Transocean (RIG), as it should benefit from investment as the oil price remains high, however, I am timid to add any further exposure, and may reduce iShares Oil & Gas ETF (SPOG) soon, as it seems oil prices may be near a peak. Also, growth is now the ‘pain trade’ and cyclical exposure among fund managers is the highest since 2006, this is forcing me to consider a rotation of capital away from the crowd sometime soon.
The Spark is a multi-asset portfolio that provides the flexibility for me to invest across equities (stocks), bonds, foreign exchange, and commodities. Traditionally, financial advisors would recommend investors put 60% of capital into stocks and 40% in bonds for uncorrelated returns. This 60/40 portfolio is dead in the water. I continue to read historical research from academics and have found that when monetary policy is restrictive, as is the case today, both stocks and bonds sell off in tandem, regardless of inflation rates. Therefore, bonds do not provide a safe place to park cash. True safe havens assets include the Swiss Franc, the US Dollar, US Treasury Bills, and Gold. If markets continue to sell off, I will consider adding these to the portfolio, and if they stabilise I will add to the factors outlined above (growth or value).
Liquidity Drives Markets
This week, huge swings in US stocks such as Meta (the biggest one day value decline in US history at $230bn) and PayPal reflected surprises in their financial results but also, stated by the Financial Times, the huge swings ‘point to what investors say has been a dramatic decline in the capacity to transact large batches of shares recently’. Both Meta (FB) and PayPal (PYPL) offer deep value at current prices, but their respective stock prices are trending lower along with the market. An often sighted adage in financial markets is ‘do not catch a falling knife’, so I believe it is prudent to wait patiently for now.
The above quote from the financial times is worrying. Liquidity — the ability to buy or sell an asset without influencing the price — is one of the primary factors influencing volatility and market pricing. The FT notes that ‘over the past two weeks money managers have observed liquidity deterioration, with costs increasing to complete large purchases or sales and prompting some to avoid putting on big trades entirely. “Intraday liquidity has dried up so much,” said Patrick Murphy, a partner at GTS, a market-making group. “I haven’t seen anything like it since March 2020.”’ Reduced liquidity leads to large gyrations in market prices on a daily basis, which can be a vicious cycle. A substantial sale by an institutional investor causes prices to gap lower, triggering traders to be stopped out of positions, leading to panic sales by inexperienced retail investors, and other investors sell profitable positions to cover losses on other stocks, and so the cycle manifests upon itself – this is capitulation selling, which investing stalwart Warren Buffet advises against in his mantra “be fearful when others are greedy and greedy when others are fearful”.
Avoid Lobster Pots
Thankfully as retail investors, we usually do not have difficulty buying and selling on a relatively small scale compared to the multi-million-dollar positions of institutions. However, I would like to warn you of several potential issues for retail investors when liquidity dries up. First, smaller companies (penny stocks or companies with a market capitalisation of less than $500mn) can be a lot more difficult to sell, as they generally have fewer shares in circulation. This is similar for trusts which invest in private markets or venture capital. Secondly, the prospect of free trading platforms sounds great on the surface (for example, Trading 212), but a huge issue with such platforms which is rarely spoken about is the use of over-the-counter (OTC) trading. These platforms essentially connect a buyer and seller. When you sell 3 shares in Company X, they are sold directly to another investor who buys these 3 shares from you, rather than being sold back to the market or broker. The issue with this is that if liquidity dries up or a market panic ensues, investors will rush to the safety of cash. If you try to sell the shares of Company X on an OTC platform in this scenario, no one will be on the other side willing to buy, meaning you are stuck in the position. In comparison, brokers such as Hargreaves Lansdown actually hold the shares in companies, so they will buy the shares from you regardless of another investor’s decisions. The above situations are often called lobster pots - easy to get in to and difficult to get out of – and should be avoided at present. If you are using an OTC market, stick to large-cap companies, and make sure you are comfortable to sit through a large decline in that stock, as it may be very difficult to sell.
On a positive note, during stagflation periods, because liquidity is highly sought after by market participants, market efficiency weakens, meaning companies are not quickly repriced to their intrinsic value. This offers lots of buying opportunities, as we see with PayPal and Meta (Facebook) today.
The Big Six
Warren Buffet (Top Left), Ray Dalio (Top Right), Stanley Drunkenmiller (Middle Left), Terry Smith (Middle Right), Bill Ackmen (Bottom left), and Dr. Michael Burry (Bottom Right) portfolio top holdings as of 30/09/2021, Source: WhaleWisdom
Looking at some of the biggest players in the investment world can give you an indication of their thoughts and outlook for markets. Unfortunately, this data is slightly outdated (September 2021), but this information can still be useful. You can search this website to view any top investor’s entire portfolio.
Looking at all six of the above portfolios as a whole, what jumps out at me is the lack of speculation among their portfolios. Of course, because of the amount of capital these investors are allocating to any one position, they are restricted to the companies they can invest in. However, all six investors have a higher weighting toward quality companies in the consumer staples and industrials sector such as Lockheed Martin, Lowes, Procter and Gamble, and Coca-Cola within their top holdings.
There may be little that is exciting about these industries to many. But as these industries sit lowest on the value chain, the companies within them tend to have strong pricing power and hence relatively stable margins and strong free cash flow. These are metrics I have insisted each company in the Spark’s portfolio has and it has paid off so far, as I have outperformed the market during the recent sell-off. These metrics make such investments defensive in times of turmoil and market panic. Often, the key to successful investing is avoiding large losses rather than making huge gains.
You also find that many large institutional investors hold the FAANGs. This is because these companies have continued to outperform over the last ten years, and many investors now feel pressured to hold them or risk underperforming their benchmarks. Also, you may notice that Berkshire Hathaway (BRK) holds a 42% position in Apple Inc. Warren Buffet started buying Apple in 2016, and the position has grown from around $36bn to $160bn today. He is stilling on a several hundred percent gain and collects $775mn in dividends from the company each year. Berkshire Hathaway’s insurance, railroad and energy businesses bring in about $245bn in revenue annually. Its position in Apple has more than quintupled, alongside huge dividend payments, and in context with the value of the rest of BRKs business, is not threatening to the overall business, hence why he holds the position. Don’t be fooled into thinking you can hold a 40% position because he does. I also mentioned last week that BRK holds a position in Stoneco (STNE), a company that I believe is an attractive opportunity. You could read a headline saying BRK has a multi-million-dollar position in STNE, and decide it would be good to put 20% of your portfolio into it. In reality, BRK holds 0.13% of total capital in Stoneco, a position that wouldn’t even move the needle in the overall profit unless in multiples more than 10-fold.
Another topic worth mentioning is shorting. Professional investors have the ability to short a stock. Shorting means that rather than betting on the price of an asset rising (going long), the investor is betting on the price of the asset falling (shorting). This is an extremely dangerous strategy, as unlike going long where there is only a 100% maximum loss if the asset goes to 0, if you short an asset, it can theoretically go to infinity (stocks can rise to any price). The problem with following a fund manager is that this professional investor does not have to declare he/she is shorting a stock, so if you see them holding a long position in a company, they may be using this as a hedge for a huge short position, so they are actually betting on the stock price going down. Do not follow any investor into such a position.
Although the fund managers have the advantage of large pools of capital and larger dividends, there are several benefits of being a private investor. First, we can be nimble moving in and out of positions easily without moving the market, where they may take several weeks to close a multi-billion-dollar position. We also have the ability to choose whichever investment we want and can choose to hold a large percentage in cash if we wish. This allows us to take advantage of opportunities quickly but also means we can sit on the sidelines when the market becomes frothy (as I have done recently). In contrast, professional fund managers must remain invested as they are not using their own money. Many fund managers are using other investors money to invest, so it is unacceptable to hold large positions of their capital in cash, as that is not why the investor gave the fund manager the money in the first place. If a fund manager holds large portions of their portfolio in cash predicting a market crash and is proved wrong, they could risk their career as investors pull money from their fund.
Overall, looking at the biggest investors’ portfolios can be an interesting exercise and provide some insight and ideas, but should by no means be the basis to inform your own investment decisions.
Action:
Adding 0.8% of capital to Transocean (RIG) at $3.78
Portfolio Return YTD: 1.4% vs S&P500 Return: -6.2%
Return since inception: 7.4%
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.