August
14
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Why July 6th turned the market upside down – Charting a new course
By David Nelson, CFA
Outside of death and taxes, there are few absolutes in life. For investors the world can be just as narrow. Fear and greed are the only things we can count on. Yes we have thousands of data points to judge companies and the health of the economy. At any given moment, some subset of that data drives security prices. However, it’s fear and greed that are the driving force in our decision tree.
Oh, I forgot… the story. There’s always a story. Some investors focus on the data, while others focus on the narrative. Smart investors learn how to put it all together to arrive at an investment decision.
Okay, you’ve done your homework. The stars are aligned.
You’re killing it. The cash registers are ringing. Your strategy is working… right up until the time it doesn’t.
You start mumbling to yourself… “I don’t understand what happened. Microsoft, Apple, Nvidia, were all working. I believe in technology. I believe artificial intelligence will set the stage for one of the great growth themes in a generation. Isn’t that what David Nelson, the Money Runner guy, said?”
Bloomberg Data
You tell yourself; “I don’t care that Apple missed the quarter or that Nvidia is now 15% off the highs. I’m staying the course. I’m a long-term investor. I am not a trader.”
Bloomberg Data
Well, that narrative works for a few days, but now your favorite stocks are down another 5%. and pretty soon profits are turning into losses. You start watching more of your favorite financial news shows, a couple of podcasts, and now you’re even more confused.
You’re one bad trading day away from opening an options account, thinking that’s the answer.
Like I said, there are two things we can count on, fear and greed. There’s one more absolute we should talk about, change. Along the way to that pot of gold, the market will change direction dozens of times. That change can last days, weeks, even years.
We’re in the middle of one of those detours right now. The signposts are right in front of you. Stay with me, people. Here’s my playbook on how to read those signs and what you need to do right now.
Welcome to The Money Runner. I’m David Nelson.
Like we discussed at the top of the pod. There are thousands of data points that each in their own way give you some insight into the health of a company or the economy as a whole.
But what if you were forced to choose just one? You’d have to choose the risk-free rate. Not just the absolute rate, but the implied level of where it will be at some point in the future. If Fed Funds or the overnight rate is 5.5%, that’s important but not as important as where the market believes that rate will be three months, six months, or even a year from now.
We’ve discussed the myopic focus investors have with the front end of the curve and what the Fed may or may not do but all the way over on the long end, rates are rising and rising fast. It started with the Bank of Japan when they loosened their bans around Japanese government bonds. That was a big deal and sent shockwaves through global fixed income and equity markets.
The Fitch downgrade of US debt raised the stakes even higher. Suddenly the narrative shifts from higher for longer to just how high are rates going?
Bloomberg Data
The above has started to play out in equity markets, with August setting up to be the first down month since the bank scare in March, forcing many investors to question the bull thesis.
Growth vs Value
The epic battle between growth and value has been raging since the dawn of markets. Growth Investors focus on revenue and earnings acceleration willing to pay higher multiples for securities that are less cyclical. Some have moats around their business models, making them less susceptible to competition. Certainly Apple, Microsoft and others fit that description.
The value investor wants growth, but not at any price and demand earnings, free cash flow and or dividends while they’re waiting.
The risk-free rate is important because it is the alternative and what all other investments are judged against. Investors spend a lot of time trying to outguess the Fed and what their next move is. Long term rates can also give meaningful insight, helping us determine which securities and investment themes are going to perform in a given cycle.
Every market is different, but right now, a 4% ten-year yield seems to be the dividing line between growth and value performance. North of 4%. Investors go back to the 2022 playbook piling into value stocks with high cash flow yields.
Bloomberg Data
We can look at this in several ways. You can see that every time ten-year rates push above 4%, broad markets like the S&P 500 start to wobble.
Up until recently, the year has been all about tech, communications, and consumer discretionary, dominated by the Magnificent 7. You know the names, Apple, Microsoft, Alphabet, NVidia, Amazon, Meta, and of course, Elon Musk’s Tesla.
Why is July 6th important?
Okay, let’s break the year down into two timeframes, before July 6th and after. Why that date? It was the second time this year, ten-year rates breached the 4% barrier. Only this time we get a clear break in market leadership.
Bloomberg Data
Check out the chart above; S&P 500 on top, ten-year rates on the bottom and in the middle, a ratio chart of Large-Cap Growth versus Large Cap Value. When that white line is heading higher, growth is outperforming. It’s pretty clear growth stalled and in fact, value has started to take the leadership role.
Bloomberg Data
Sector charts are also a good tell. In the first half of the year, we see the massive outperformance of growth sectors over value.
Bloomberg Data
After the July break, the chart flips upside down with energy on top. Look familiar? It should. It’s very close to the 2022 playbook.
When the COWZ come home
Bloomberg Data
Here’s another signpost. Sometimes you can get direction from ETFs that are starting to outperform the broad market. Pacer US Cash Cows (COWZ), which focuses on stocks with high free cash flow yields, was the darling of 2022 coming in just positive on the year. That was a home run in a year when the broad market was down more than (-18%).
Bloomberg Data
Once again, this ETF has a heavy overweight to high free cash flow energy stocks, which currently make up more than 37% of the portfolio.
Free Cash Flow –what is left after a business pays its day-to-day operating expenses. Thisis the common denominator of most value models. If current trends continue, you’re going to need something more than just The Magnificent Seven to navigate the current detour.
There’s an old saying that markets do their best to inflict pain on the most people. For the last couple of years, investors have rushed from one side of the lifeboat to the other, trying to stay ahead of prevailing investment themes in large part dictated by the perception of where rates are heading.
Bloomberg Data
Growth has been the hands down winner in the first half of the year with energy taking a back seat. Today, you can turn that upside down as energy, along with other laggards like healthcare, are currently leading the pack. Oil’s not in the sixties anymore. Each stairstep higher adds to the revenue, earnings and cash flow of most companies in the oil patch?
What can we use as an early indicator on sector leadership?
Bloomberg Data
Watch ten-year yields. It’s a pretty good trigger. If it starts trading sustainably below 4%, increase your exposure to tech. Above that level, you’re going to need some of these high free cash flow sectors and securities to balance out your portfolio. If you’re looking to keep it simple, add COWZ or another value focused ETF.
All of the above begs the question; What happens if ten-year rates keep climbing?
What about 5%? How about SIX?
Then nothing works. There’s a rising tide of concern that the US may have hit debt and deficit levels that combined are giving investors pause. That very large elephant in the room is the cost to service our debt, which is on a clear path to $1 trillion, more than even our defense budget.
We’re only ten months into the fiscal year and already Washington has ballooned a peacetime deficit past $1.6 trillion.
The quiet whispers making the rounds of trading desks and large investment houses is the term credit event.
I said earlier, there are three absolutes in markets… fear, greed, and change. It’s pretty clear which one of those will be the dominant emotion if the U.S. fails to get its act together.
We can have the conversation now or wait until the world wakes up and realizes the Emperor has no clothes.
*At the time of this article some funds managed by David were long AAPL, MSFT, NVDA, META, GOOGL, AMZN and TSLA
DAVID NELSON, CFA 