Category: Market Trends

Why the Next Two Weeks Could Determine the Rest of 2022

Posted on by io-fund

For most of August, we have been providing free webinars in prior blog posts outlining an “imminent pullback.” You can access these here, and here. In this article, we will discuss key levels that must hold in order to maintain a long-term bullish bias. We also discuss why a direct drop to new lows may not play out, even if the bear market resumes. We then discuss the supporting markets that need to work in unison with equities before we can see a meaningful uptrend resume.

There is a popular saying on Wall Street – equity markets are discounting machines. In other words, equities are looking 6-9 months into the future to create prices today. Because of this fact, we regularly see market scenarios that sometimes do not make sense.

For example, in April/May of 2020, the high-frequency data was literally off the chart. We were seeing record unemployment, as well as PMIs falling off a cliff. This was coupled with companies in the service sector reporting losses that were nearly unprecedented. Yet, the market powered higher as this data continued to come in week after week. Ultimately, the market was right, as the US economy saw a relative recovery, and avoided the worst-case scenario.

We saw this phenomenon again last month. The June CPI number hit another 40-year high, beating consensus expectations. This was followed up by the Producer Price Index beating estimates to the upside, which implies rising inflation into the future. We then saw bank earnings come in mixed to bad, kicking off the feared earnings contractions brought on by over a year of real earnings seeing MoM declines due to wages unable to keep up with inflation. On the back of this bad news, the market failed to make a new low, and instead rallied nearly 700 points into late August.

When we see the market rally on bad news, what the discounting machine is telling us, is that all the bad news that is currently known, and can be modeled, is now priced in. We tend to see markets bottom in a place of despair, with most market participants certain we are going lower, while markets tend to top into euphoria, where most market participants are certain we are only going higher.

How to Model Investor Sentiment

The inability to model investor sentiment has been an ongoing issue with economic models for many years. It was one of the primary issues in 2008 when most models failed to see such a dramatic drop. Sidney Winter, Wharton School Professor, stated, “As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions. Commonly missing are hard-to-measure factors like human psychology and people’s expectations about the future.”

The only way to truly model investor sentiment is through technical analysis. Market patterns show up time and time again throughout history and across all assets being traded between humans. The art of properly interpreting these patterns can help investors get ahead of big moves.

The market pattern we are currently trying to interpret in real-time is a corrective pattern, which will unfold in 3 legs: A wave down, B wave up, C wave down. The question for the remainder of 2022 is simple – is the current 3 legs of the bear market that bottomed on June 16th the entirety of the correction, or is it just the 1st leg of a much larger correction?

We should know the answer to this question within the coming month. Assuming that the June low was the low, the current uptrend would be developing a new large-degree 5-wave pattern off the low.

As of now, we only have 4-waves. So, in order for this to be true, we need to see the market bottom soon, and then push back above the 4330 SPX level. This would give us a clean 5-wave pattern off the low, which would be wave 1 of the larger 5-wave uptrend developing. Here is a visual to show what this would look like.

Chart showing a 5-wave uptrend

If we instead break below 3920-3900, then the odds favor a continuation of the bear market. However, I would not be expecting a straight drop, if this does happen. Assuming that we are currently in a large degree bear market bounce (B wave), there is one major clue that we do have to help us determine where this bear market will take us. The move from the ATH to the June low occurred in a rather straight-forward 3 wave fashion.

Chart showing a 3-wave move

Note how the make-up of this larger 3 wave move was 3 down, 3 up, and then a 5 wave move into the June 16 low. If this is only the first leg of a larger bear market, it appears to be in the form of what is called a Flat corrective pattern. If this is true, then there are only 3 Flat Corrective Patterns to consider for an outcome.

3 Kinds of Flats corrective pattern

Note how in each Flat corrective pattern, the B wave (up) retraces a large portion of the A wave down. If we are in an Expanded Flat, the B wave makes a new high before the final leg drops to new lows. In my experience with Flat corrections, we tend to see the B wave retrace at least to the 61.8% retrace level of the entire A wave, and the B wave tends to be nearly as long as the A wave in time.

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As of today, we have come close to this target in price, yet we have fallen short in time. Playing the probabilities, it is highly irregular to see a Flat corrective pattern’s B wave be so brief relative the length of the A wave down. Anything is possible, which is why we plan to stick with the probabilities until critical supports break. If this is accurate, we are likely more than halfway through the bear market bounce. Once we bottom in the current selloff, as long as we hold the 3720 level, we should then see a 5 wave rally to a new local high into Fall.

S&P 500 TradingView chart

Inter Market Analysis

Our economic grid analysis has moved into what we call the Big Risk-Off grid for the first time since 2020. This means that the rate of inflation is slowing along with the rate of economic growth.

Graph: economic grid analysis

Historically, this grid tends to accompany the C wave down in a bear market. However, in 2022, the market exhibited a sell-now-and-ask-questions-later mentality, as we saw the S&P 500 decline by 24% and the NASDAQ-100 decline 34% over a 5.5 month period. These are rare moves, and one has to wonder if the worst is priced in – including the global slow-down in growth? I do believe it’s cavalier to assume that at this point, and prefer to let the broad market prove it to me over the coming month. We will remain cautious until then, and respect the Big Risk-Off grid that we are now in.

If we have, in fact, found a meaningful low, we would not only need to see the S&P 500 give us that 5th wave up, but we would also need to see rates, the USD and oil move down or sideways. Bull markets do not happen in vacuums and tend to be supported by various markets firing in unison. As of today, this confluence of inter-market dynamics is not supporting a direct uptrend in equities.

Bonds

We have talked for several months about how the bond market is not buying what the equity market was rallying on. If we did just to see peak inflation in the U.S., we would then expect the bond market to start trading on the global slow-down in economic data. This would cause a bid under bonds, as the bond market scrambles to lock in high yields as the economy moves towards a deflationary event. However, we are seeing the opposite.

TLT Nasdaq TradingView Chart

This suggests that the bond market is not yet convinced that inflation is behind us. Until TLT moves past $117.50, the odds remain that rates have not peaked, yet. If rates continue higher, expect volatility to follow, as companies must reprise their future cash flows/earnings due to rising borrowing costs.

The U.S. Dollar

The dollar (USD) has also been a catalyst for volatility in 2022. The USD has seen a sharp uptrend, drying-up international sales and thus affecting revenues. With peak inflation behind us, a FED pivot would likely start getting priced into the USD along with stocks.

Furthermore, The EU just posted the highest CPI and PPI readings sin e the inception of the Euro. Furthermore, Germany, who accounts for nearly 30% of the Eurozone economic output, just reported that consumer costs rose 8.8% vs. 8.5% a month prior. This is the largest increase since 1973, and far exceeds European wage growth of 3.8%. Therefore, the EU has accelerating inflation that far exceeds wages.

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The reason this matters is because the U.S. has potentially seen peak inflation, with data surprising to the downside.

The FED is far ahead of the ECB in terms of rate hikes, which means the EURO is likely to head higher, as the USD starts topping. As the FED reverses course to flight deflation, a loose dollar would be implied, causing a peak in the dollar. We are simply not seeing that yet. This implies that global fears are still present, as investor rush to the safety of the USD.

US Dollar Index Chart

The Dollar Index, DXY, is hitting a confluence of big resistance on weakening momentum. If we see a strong break above the 45-degree line (1×1 in red) it could spell trouble for equities. As of now, it is holding the resistance, which we now need to see a follow-through to the downside to relieve pressure from equities. 

Energy

The Oil market is also looking ready to push to new highs. The global economy is slowing down, making the need for energy less than it was a year ago. However, the crude oil charts look primed to make a new high.

Crude Oil Chart

What would cause a push to new highs is yet to be known. However, in the face of slowing growth, it would likely be a catalyst the market is not pricing in yet. Many times, markets provide warnings that a new risk is on the horizon, and if we are to see a new leg lower, it would likely be a catalyst that is not known or being taken seriously.

Potential Catalysts

Next week, we will discuss the most concerning catalyst for the continuation of a bear market in our free newsletter. Here is a secondary catalyst we are tracking:

China/Taiwan:

Taiwan is an island off of the Chinese mainland that was governed independently from China since 1949. China views the island as a renegade province and has repeatedly threatened to force submission to Chinese law and political views. In 2016, the election of president Tsai Ing-wen, was a statement that the people wanted a further divide between Taiwan and China. Tsai instilled a movement of separatism and nationalism, which goes against the vision of the Peoples’ Republic of China, which continues to build today.

These tensions have continued to escalate into 2022 where they have reached a boiling point. We have seen numerous threats from China, coupled with Taiwanese leaks that seem to be preparing their citizens for war. Whether this will escalate or not is yet to be seen.

However, like Russia’s military drills in the region grew just before an invasion, China’s military drills continue to grow in the Taiwanese region as well. It also does not help that Russia and China have engaged in joint military drills recently, as the US announced that it has sent two warships to the Taiwan Straight.

If we do see an invasion, expect crude oil to move to new highs. This will put pressure on global oil markets, which will likely push inflation concerns higher, causing bonds to continue their decline as the USD is bought as a flight to safety.

Conclusion

The biggest tell will come from the US equity market over the next month. If we can get that 5th wave up, the US market is leaning towards the low being in, implying that the catalyst for a C wave lower is unlikely. On the other hand, if we break below 3975, the equity market is telling us that something is not right. The great discounting machine will be discounting something the rest of the market is simply not aware of until it is too late.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

The Motley Fool Podcast: Beth Kindig on Tech Stocks

Posted on by io-fund

I/O Fund lead tech analyst Beth Kindig joined Motley Fool analyst Deidre Woollard on podcast about Women in Investing to talk about the recent downturn for tech investors and how Beth and I/O Fund are weathering the storm.

It’s been a bumpy road, but despite that, I/O Fund and Beth Kindig continue to be buyers. “When we see a quality company being down in price, we try not to overthink it, because there will probably be a day where we will talk about the prices of 2022, meaning that they were so low,” says Beth. “The probability that 2022 was oversold is pretty high at this point. It was just an extreme reaction to the downside, as part of 2020 and 2021 was an extreme action [in] the opposite direction.” 

Both Beth and I/O Fund are part of the 2030 club – meaning that we are both fully invested in tech through 2030 at minimum. Especially with tech stocks, Beth says you need to have at minimum a 3-year hold, and ideally a 5- to 7-year time horizon. She notes that her 2018 and 2019 entries are doing very well right now because she has held them for 3+ years.

Regarding the last earnings season, Deidre mentioned that although there were a lot of companies that reported some pretty strong results, the market kept reacting negatively, asking if it represented an opportunity for Beth. The I/O Fund pays really close attention to earnings, and when a company has a really strong report and the market sells off, that’s usually a buying opportunity for I/O Fund. Beth notes that while I/O Fund uses a combination of fundamental and technical analysis, as a long-term buy-and-hold tech industry analyst, she looks for management to give an outlook.

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Beth notes that even if she doesn’t own the stock, she listens to the heavyweights in adtech because they give you a broad look at the adtech industry. “They have visibility that we don't have,” says Beth. “Analysts can obviously go into channel checks, but channel checks aren't nearly as good as having visibility at the company, and the right management teams are trying to build trust with investors.”

Looking forward to next earning season, Beth states that she thinks the supply chain will have a rebound in the second half of this year – specifically noting the big auto inventory rebound in Q4 of 2021. “We're hoping that funnels through by the second half of the year,” says Beth. “If so, all kinds of industries will start to be positively impacted. Adtech, especially, I would say is one where if it can't come in the current guide, we really are watching it for the Q3 guide, which would be an adtech rebound due to supply chain issues easing. That's one to look for. What we try to remind people is that perfect timing is impossible.”

Listen to the entire podcast and read the full transcript of the interview here.

Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.

Timestamps:

00:00 – Intro
00:30 – Air Travel Market
06:25 – Media Stocks
13:30 – Sleep Number
19:05 – Beth Comes In
23:00 – Beth Discusses Earnings and Sentiment with Regard to Earnings
26:42 – What Beth’s Looking for (Also includes Supply Chains and Quarters Data)

Another Cyclical Slowdown within a Secular Bull Market

Posted on by io-fund

Even though the larger cyclical growth trend is slowing, we are seeing unexpected signs of a temporary and unexpected bounce in growth. With inflation likely peaking, the FED beginning to walk back the most hawkish path of rate hikes this year, we could set up a much needed rally in high beta stocks from historically oversold conditions. This also lines up with our technical analysis work, all of which we discuss below.

We do plan to use any move in high beta stocks from here to further de-risk and raise another round of cash. We raised cash in December/early January, and have used that cash to layer into the companies that we want to own for longer than 1-2 years. On a short to intermediate-term time frame, we believe the upside risk from current oversold levels is higher than the downside risk. On an intermediate to long-term time frame, the risk will likely be more to the downside until the 4th cyclical slowdown within the larger secular bull market runs its course. Regardless, we believe the odds that the end of this great secular bull market is quite low.

The type of bear markets that go deep and last for years happen in conjunction with recessions. With the Yield Curve NOT inverted, nor giving any sign of an inversion in the near future, the current consensus odds of a recession are close to zero. Instead, what we are likely experiencing is the 4th deflationary shock in an ongoing secular bull market. We experienced these shocks in 2011, 2015, 2019/2020, and now 2022. these shocks are emotional and sharp but tend to recover quickly with a renewed reflationary impulse. Nobody can give you an exact guarantee, however, this is the outlook we are using for our current portfolio positioning. If something changes, we will let you know.

Inflation vs. Equities

Historically, rate hikes cause a knee-jerk reaction by markets rotating assets over the short term; however, we tend to see sharp snapbacks to new highs once that rotation subsides. Rising rates imply a strong economy.  As growth and inflation rise together with the Fed Funds Rate, we tend to see strong moves in the stock market.

For example, in December of 2015, the Fed raised rates for the first time since 2006. This created a short-term top as the S&P 500 fell 11%. Within 8 months the market was back at ATHs. From there the FED raised rates aggressively, as inflation, growth and the markets began to advance together on one of the best years within the secular bull market that started in 2009.

Today, we seem to be getting a similar reaction, yet at a more aggressive velocity. So, what happened? The short answer is that the FED has never waited this long to raise rates. Their “transitory” inflation stunt last year, coupled with inflation targets in the second half of 2021 that were also wildly detached from reality, placed them between a rock and a hard place.

On one hand, now that inflation is elevated, we are seeing the results of this reality filter through the economy. For example, real hourly wage growth is at an annualized pace of 12%, which is very inflationary. Yet, this growth in wages is still not enough to keep up with the annualized CPI print, causing real wage growth to be negative. Another example is that Real GDP grew at a 6.9% annual rate in Q4. Even with this excellent Q4 beat, real GDP for 2021 was only 1.6% (growth minus inflation), which was slower growth than the pre-COVID trend.

On the other hand, we have the U.S. Equity Market, which is dependent on an ongoing infusion of liquidity to maintain support. Though there is some room to deflate current prices in equities, letting the market crash for a sustained period is also not a viable option. Unlike in prior decades, the pivot towards manipulating a “Wealth Effect” in 2009 through FED policy, coupled with the near-universal adoption of 401Ks, over a decade of mostly 0% savings rates forcing money out of savings, and Wall Street’s infiltration of public and private retirement funds, has fundamentally tied the stock market to the economy.

The FED is now faced with allowing inflation to further erode growth, which is affecting middle to low-income households or attempting to deflate the stock market by focusing on curbing inflation. Going into Jan of 2022, we got the answer to that very difficult question, which was further backed by the recent FOMC Q&A. The market was expecting 1-2 rate hikes going into 2022 with a targeted roll off of QE to be in June-July. They then announced that 4 rate hikes were needed and an end to QE in March. This sudden increase of actions caused a panic out of risk assets and into energy, financials and various defensive assets, which is still playing out.

On top of a rushed tapering announcement, we have further evidence building that the cyclical growth in the global economy is peaking. So, unlike 2017 where inflation growth and rates rose together, we have the FED rushing to raise rates with growth and likely inflation peaking. Once again, this is unchartered territory, as the FED has never waited this long to act, which is creating uncertainty that is showing up in market volatility.

Like many, we did not expect such a sharp selloff so early into 2022. I do believe the market has moved too far too fast, which is common with market sentiment. This has set up the pricing in the worst-case scenario, and created oversold conditions that noticeably outpaced March of 2020. With sentiment at extremes, we only need the slightest upward surprise to trigger a reverse rally, which I believe the bond market is signaling.

How Bonds Relates to Tech and Why This Matters

Tech growth is considered a long-duration asset. When a stock has no current cashflow or earnings, yet is showing strong top-line growth with a large runway to expand, you are in essence buying a stake in the future cashflow of that business. These cashflows are far out in the future but are assumed to be very large. They are then discounted back to the present-value. Thus, a small change in the discount rate on the long duration cashflows has a material impact on current valuations.

As inflation rises, the costs associated with these company’s day-to-day businesses becomes more expensive. Furthermore, if they require on-going debts to fuel growth until profitable, the cost of borrowing goes up with an increase in yields. This forces the stockholder’s future stake on the company’s profitability to get repriced.

Equity investors are focused primarily on a company’s fundamentals and price action. Bond traders, on the other hand, are focused predominantly on economic growth and inflation. This is what drives the bond market, except for one key factor – FED policy. Because the Federal Reserve controls the Fed Funds Rate, which is the target yield set by the FOMC for commercial banks’ lending excess reserves overnight, this action filters out across the yield curve, having a greater effect on yields the closer you are to the Fed Funds Rate.

In other words, the closer a bond’s duration is to the front end of the curve, the less it is affected by growth and inflation expectations, and the more it is controlled by FED policy. As we move farther out on the yield curve, FED policy has less of an effect on bond buying. Instead, growth and inflation expectations drive these yields. This is important to understand when discussing what’s going on in the greater macro environment.

If growth and inflation expectations are driving long-duration yields, what does this mean for the recent upward moves in the 10-year yields across the world (Ex-China)?

With the CPI at 7% and the 10-year yielding 1.75%, the real yields on the 10-year are currently -6.25%. Inflation is obviously affecting the 10 year yield. However, with evidence that inflation is peaking, which will likely rollover in a decelerating economy, as well as evidence of one-time events not moving into 2022, the 10-year is likely also picking up on an unexpected and temporary growth surge.

Inflation

In 2022, the only major assets and sectors that are up are Energy, Oil, Commodities and the Dollar. In fact, the energy sector is the only sector that is up YTD, showing 17% gains in one month. Inflation fears are high and the expectation is that the 10-year yield is destined to reach 2.5%, and likely never see sub-2% again. All of this could happen, but I do not believe this is what’s causing the 10-year yield to make a higher high. Here are some points that show inflation may be peaking soon.

  • Our model measures the Rate of Change in both Inflation and Economic Growth. This matters because even though we are seeing a high reading of 7% in the CPI, the rate of change is slowing.

Note how Nov-21 marked a lower high in inflation’s rate of change than May-21. As we entered December, inflation is slowing and trending towards deceleration.

  • The recent CPI number showed a slowing down of both food and energy, which is a trend that will likely continue to further fuel the deceleration in inflation into 2022. With energy showing a noticeable topping pattern, a drawdown will bring inflation numbers down further.

The advance is oil prices is showing a strong divergence within the RSI, suggesting the upward advance in oil is due for a pullback. This would relieve the inflation pressures on the economy, pushing yields down and potentially being a temporary catalyst for long-duration assets.

  • Last Friday, we also saw the FED’s preferred method for gauging inflation, PCE, was up 5.8% on a YoY basis, while the core PCE was up 4.9% on a YoY basis. These are high numbers, which have been fully priced into stocks, yet they were well below the worst case scenarios. Moving into February and March inflation metrics will have higher comps to clear on a YoY basis, which should provide a cushion. As long as we continue to see CPI and PCE either come in-line or surprise to the downside in 2023, we should see buyers step back into the risk market.
  • From recent earning calls the one theme that is universal is the ongoing supply chain disruption, which is certainly contributing to the inflation we are seeing throughout the global economy. Interestingly, the continued trend in recent PMI reports as well as the Empire State MoM delivery Times Index are showing that purchasers are reporting quicker delivery times, which suggests that we have reached peak supply chain issues, and should see a further resolution in 2022.
  • The supply chain disruptions have forced businesses to build up their inventory, which has also contributed. The excellent Real GDP Print in Q4 was largely due to this inventory buildup, as businesses have reacted to the supply chain issues in 2021. This increase in inventory will not be repeated going into 2022 due to signals of a recovering supply chain and a cyclical slowdown in global growth.

All of the above data points suggest inflation should start to ease. This was further backed up by recent statements from Mathias Cormann, the secretary general of the OECD. Corman claimed that inflation should start to ease as global central banks update their policies to pre-pandemic levels.

Furthermore, the bond market is also suggesting an inflation slowdown, which is running counter to the popular narrative that inflation is only going to get worse. If inflation was going to remain elevated and continue upwards as a secular trend, we would likely see more of a reaction the further out on the yield curve we move, as well as a continued upward move to the 10-year yield.

Instead, with the 10 year making new highs and holding below the 2% line, the 30-year, which is looking more at longer cyclical trend in growth and inflation is still in a noticeable downtrend.

In other words, the bond market is not buying that the inflation (as well as growth) will continue its upward trend on a longer-term time frame. Instead, the 10-year could be signaling a temporary reprieve, which is not fully being priced into the equity market, and the 30-year is signaling that if this manifests, it will not be sustainable before the bigger cyclical slowdown resumes.

Growth

The below model measures various growth metrics within the U.S. economy that tend to be leading indicators for the market. This is important because cyclical growth affects the far end of the yield curve. Visually, you can see how the economy was slowing down going into the COVID crash, and how it appears to have peaked in Q4 of 2021.

 This is confirmed with recent data worth pointing out:

  • Industrial production came in at -0.1% on a MoM basis, which compares to the historical average of 0.74%. This was well below the expectation of a 0.3% increase.
  • Retail sales also came in at well below expectations of -0.1% with a -1.9% MoM reading.
  • New Orders missed expectations.
  • The same can be said with manufacturing and business activity. The Manufacturing PMI came in an 11 month low, also surprising to the downside as it dipped below its 1-year moving average. The last time this happened was in September of 2018.
  • PMI in Services came in relatively strong; however, we needed more growth in this area of the U.S. economy to offset the decline in manufacturing.
  • This was further backed up with the recent ADP employment survey showing the economy lost 301,000 jobs in January, which was well below the expectation of an increase of 200,000. This was the first decline for ADP employment since December of 2020, and it was led by services.

 

Economic Conditions and Consumer Sentiment

Economic conditions, as measured by the US Current Economic Conditions Index, are at a similar measurement as March 2020, while consumer sentiment actually was lower in December than at the March low in 2020.

The reason for this is that though average hourly wage growth is up between 5.1% and 4.7% on a YoY basis over the last 2 months, real wage growth, when factored in for inflation, is down between -1.75% and -2.4%. As you can see in the above table, real wage growth has been negative since April of 2021, which has certainly been one of the main drivers for the deceleration in consumer sentiment that is filtering into economic growth.

Why is consumer sentiment so important? There are a few simple factors that when present, have preceded deflationary shocks to the stock market and economy. Consumer sentiment is one of them.

Going back to 1987 there is a clear correlation between consumer sentiment and stock market events. As consumer sentiment diverges from the stock market’s uptrend, what tends to follow is large correction or bear market. Today, we are seeing consumer sentiment hit levels that we last saw in 2011, which is something investors should be aware of.

The reason for this correlation is quite simple. If consumers feel good about their financials, they tend to spend more money on discretionary items. What tends to affect this sentiment, aside from a rare black swan event, is that inflation rises faster than wages. As consumers feel their real wages decline, they tend to spend less on discretionary items, and in periods of heightened inflation, consumers tend to take out debt to cover living expenses, which is what we have been seeing in the last half of 2021.

It’s important to know where we are in the business cycle for both short and long term investors. The larger cyclical trend is certainly suggesting that we have reached peak growth or close to it. However, recent data is providing some green shoots that the consumer is starting to feel better about the economy.

  • The Conference Board released their monthly Consumer Confidence index and report in January. Even though it fell to 113.8 from 115.2 in December, it was above the expected decline to 111. They acknowledge that the surprise was that even though inflation is high, and real hourly wages are down, the average consumer is still planning to buy homes and large ticket items including cars over the next 6 months.
  • This positive upside surprise was even further backed by Visa and American Express’s recent earnings call. AMEX said that card members’ spending was at an all-time high. They also confirmed that consumer travel and leisure spending is finally above pre-pandemic highs. They further claimed that they believe travel and leisure spending will continue to boost their revenues through 2022.
  • UPS recently reported a strong beat on both the top and bottom line. Their top-line growth showed a 11.5% YoY increase, which they claim was the result of strong e-commerce demand. They further raised their guidance for 2022. UPS further noted that they have raised their prices do to supply chain disruption, and the consumer has shown a willingness to pay these higher prices.
  • Two Federal Reserve chairs came out this week easing the probability of the most hawkish FED response in 2022, which has been priced into the equity market. The Federal Reserve Bank of Philadelphia President Patrick Harker expressed that the supply chains have a lot do with inflation pressures. He believes that 50 bp hike in March is not necessary. This approach was also expressed by the Atlanta President as well as the San Francisco President, supporting a more tempered approach to rate hikes in 2022.

With sentiment at rock bottom levels, this potential temporary return to growth, and likely peaking of inflation, which the bond market could be signaling, would be the catalyst that leads to a short to intermediate-term reprieve from the larger cyclical slowdown taking place. If this scenario manifests, and/or we see the FED continue to let up on the most aggressive plot program for 2022, we expect to see a bid in risk assets.

Is Tech Growth Over?

What will happen to long-duration assets and high beta when the larger global growth slowdown resumes, and if/when inflation continues its deceleration into 2022? Right now, many tech innovators are showing strong forward growth and even raising guidance into 2022, yet their stock is down anywhere between 30-70%. With growth assets left for dead, this would be the ideal environment to see a multi-week to multi-month relief rally that could last throughout the remainder of Q1 2022.

This is also lining up with our broad market Technical Analysis in the S&P 500

The above scenario lines up with the macro thesis outlined. It would suggest a multi-week/multi-month rally to ATHs within the broader market. This is supported by extreme sentiment readings. For example, the S&P 500 recently hit 22 on the daily RSI, a level only seen 5 times in the last 20 years, and each time showing positive returns 6 months from that reading.

On a micro view, it appears that the current bounce is still within the range of being a 4th wave within a 5 wave decline. Considering that the current c wave down is only showing a distinct 3 waves down, I wouldn't be surprised to see the market trend down into a lower 5th wave to complete the correction that started 9 weeks ago. If we do get another low into the Feb 3-11 time factor, I would consider this strong evidence that the above thesis is in play. 

On the other hand, if the market moves above 4585-4600, that will complicate the above scenario on a technical basis. I would not like to see us trend up into the February time factor after only giving us 3 waves down. My current count, for reference, has us in the final leg lower now, but we would need to see one more leg to retest the lows, at minimum. If we do not see this, It would mean that we have likely only experienced the first leg down, the current bounce is a b wave, with a c wave to follow to new lows. We will simply need to see what the coming week gives us.

If we do rally to new highs, once this rally finishes, we will likely see a larger deflationary correction in both price and time. So, any rally that we get would be an opportunity to de-risk as we head further into 2022. Note the larger degree (4) wave in our future (shown above). this lines up with the slow move into the deflation/stagflation macro quadrant.

Keep in mind, as inflation and economic growth start their decline, it is only a matter of time before stocks get the message in a meaningful way. Because this Deflation/Stagflation cycle is looming over any short-term economic boost, it is likely only some indexes and some sectors will make new highs while others make lower highs. This is common with risk assets. They tend to lead us into slowdowns and lead us out, which appears to be the case, so far.

For example, one of our favorite microtrends in play, which is only in its middle innings, is Cloud. The best proxy for this trend is CLOU, which is an ETF of cloud pure-plays (shown below).

One thing that is undeniable is that the excess sentiment from 2020 in high tech began to correct in February of 2021. As the broad market moved forward, cloud, which is arguably the strongest microtrend in tech right now, is providing us with a very distinct corrective pattern outlined in blue. This would suggest that this flush-out in January could setup the next large degree uptrend.

Even with this potential on the table, I’m leaning more towards the red path. This suggests that the high beta tech world is experiencing its first leg down in a larger degree 2nd wave drawdown. Like we see with high beta, they tend to lead us into and out of larger declines. So, as SPX and the DOW would potentially make a new high, continuing their uptrend, high beta would be in a b wave. Thus, we would see high beta bottom first, and begin its new uptrend as the broader market likely makes one more lower low.

Conclusion

Regardless of what plays out, we believe that valuations in key names are oversold and setting up for a decent comeback. As long-term investors in tech trends, managing sentiment is crucial. Though cloud is growing and well within the middle innings of adoption economically, the sentiment regarding the stocks that are setup to benefit from this growth experience wide and emotional swings. Just like we saw an exuberance stretching sentiment in one direction in 2020/Q1 of 2021, we are now seeing the reverse effect, which we believe is setting up great buying opportunities amongst specific names for long-term investors willing to ride out any further volatility, which is likely.

We do believe the market shifted into a risk-off investing environment in Nov/Dec of 2021 due to the realization of peak growth and the projections of peak inflation soon after. However, the consumer is starting to perk up, appearing to accept the new norm of heightened inflation. This, coupled with the real possibility of a post-pandemic economy and heightened inflation, is causing long-duration assets to get sold, which is affecting tech growth. When coupled with the oversold conditions in tech growth, the macro environment could be setting up for a recovery rally that could last well into 2022. However, we see any renewed uptrend as an opportunity to de-risk, and raise some cash until the global growth story bottoms and begins a new cycle.

Microsoft, Tesla and Apple’s Strong Results Are Great for Tech Stocks

Posted on by io-fund

Microsoft, Tesla and Apple reported last week (week of 01/24/22) and results came in strong across the group. Investors needs to stay aware of what these companies are doing as they can impact numerous industries, such as semiconductors, cloud and even financial/insurance markets.

Microsoft, Tesla and Apple strong results will likely be a tailwind for the broader technology complex. For example, Tesla, Microsoft and Apple are ramping capex, which will benefit key industries such as semiconductors.

As shown below, Microsoft has ramped capital expenditures, which has been driven by its expansion of cloud computing. This is a strong tailwind for cloud companies, and highlights that cloud remains an area of hyper growth.

Watch the video below for a quick recap of Microsoft, Apple and Tesla's latest earnings release and the impact that they have on the broader market.

2022 Memory Market Update

Posted on by io-fund

A trend that we are watching closely at I/O Fund, heading into 2022, is the memory market. Memory storage is struggling to keep pace with the explosion and data that's being created in the cloud environment so 2022 might be a big year as new technologies hit the market. Tech Analyst Bradley Cipriano touches on what these new technologies are and who's likely to benefit in 2022.

A major new technology is 3D NAND. Key players that have innovated around this technology are Micron and Samsung.

The chart below displays the TTM Capex of prominent companies in the memory market, highlighting that investments are being made now in anticipation of strong demand in the future.

For more on the memory market and to hear about what specific companies are doing to measure up, take a look at our newest YouTube video.

Market Snapshot: Why This Dip is Different Than February of 2021

Posted on by io-fund

Going into February of 2021, we warned of a selloff based on weakening momentum trending into an important broad market time factor. We used this opportunity to raise some cash and even had a proactive hedge on QQQ at the time. This shift helped us remain competitive with the pros in the growth markets, as did our proactive move out of crypto (and back in again). Even when the growth selloff intensified into late Q1, many were calling for the end of the bull market, as we used that opportunity to add to some quality companies that were getting beaten up. Like many, we underestimated the difficulty in the high beta market, showing mixed results in our additions to high conviction/long-term plays, but we continued to hold the broader thesis that the bull market is not over, as we do today. I do believe we will see a return to 2020-style growth investing before this great bull market is over, but I also believe that we will get a chance to grab shares of targeted companies at lower prices first.

 

That being said, what I do want to point out is the difference between February 2021 and today. The economic environment tends to lend itself towards high beta being in favor or out of favor. Coming out of the 2020 bear market, we saw a large acceleration of economic growth with low inflation – ie, the perfect environment for our world. As inflation picked up in mid Q1 of 2021, growth investing became more difficult. We still saw numerous winners in this field coming out of the February/March selloff, so a more discerning filter really paid off. The reason for this is that we saw inflation and growth accelerating up at the same time. However, today's dip in growth assets and rotation into more deflation protection assets is signaling something different, in my opinion. I believe looking at the growth trends in the macro-environment will help clarify what that is…

 

First up, we'll look at our economic heat map. 

Note the difference between February of 2021 and today. In February, inflation was starting to pick up but wasn't a major concern (according to the bond market). Also, note how we were in the early stages of accelerated growth in the US economy. Now, compare that to today – growth is starting to slow as our models expect the rate of change in this deceleration to start turning soft red in mid-late Q1. With inflation in the red as well, we also are expecting this slowdown to lead to inflation slowing down as well. We are seeing signs of this slowdown globally with China leading the way. Much like we saw a global growth push in 2017, the macro environment is suggesting a global growth slowdown into 2022.

 

Our quadrant analysis, which measures the Rate of Change of both growth and inflation in the US, is supporting this thesis.

The October data is being uploaded soon, but it will have the Oct. numbers closer to the bottom right quadrant – inflation/stagflation. This is a risk-off macro environment where high beta struggles, and we see a flight to real estate, utilities, staples, long-duration bonds, and very liquid mega-cap growth companies (exactly what has been working over the last month). We do believe this quadrant will take us into the lower left quadrant (deflation) in 2022. 

 

With this in mind, think of the FED's position. They waited too long to raise rates so are under the gun to rush this process in order to have ammo to fight the next deep correction. So, with growth slowing, inflation peaking, and the FED in a rush to tighten conditions for the next reflation attempt, probabilities suggest that risk assets will continue to struggle until a floor is found in the economic slow-down.

 

But, don't take our word for it, just look what the bond market is saying.

Remember, long-duration yields are controlled by market expectations of growth and inflation (not the FED). As long-duration yields go down, it's signaling the same slow down our models are showing. The spread between the 10-year yield (not affected by FED policy) and 2-year yield (highly affected by Fed policy) has seen the sharpest flattening since 1994. 

 

Interestingly, this also lines up with our Elliott Wave analysis. I have always been amazed at how using Fibonacci/golden ratio analysis on charts tends to predict future outcomes. Anyone that has been with us for a while knows that we've been talking about 2022 being a tough year based on this analysis alone. We now have a combined macro analysis, coupled with inflation and FED policy catching up to what Elliott Wave was predicting over a year ago.

Trends move in 5 waves in the direction of the predominant trend. this is true in all markets and on all time frames. Since March of 2020, the predominant trend is up. We have a clean 1st and 2nd wave in place (in red). In order to complete the minimum targets for the 3rd wave, we need the current trend to move us into the SPX 4900-5200 region. This will lead to the larger 4th wave, which we expect to be between a 10%-15% drawdown in early/mid-2022. We also have two important broad market time factors coming up – Dec 27-Jan 3 and one in late January (I'll narrow down the focus as we approach this). Almost every chart I map is showing the same inflection points.

 

These time factors are marking inflection points and how the market trends into them will be crucial. Interestingly, they are also lining up with what our models are suggesting – an acceleration of the global economic slowdown in late Q1 (remember, markets are looking into the future, so expect a top prior to the data coming out). Furthermore, if we look at inter-market signals, a similar warning is still present.

Our risk-on and economically sensitive sectors are diverging from the broad market. When we see this pattern, only one of 2 things will happen: (1) either the broad market is leading the risk-on sectors; (2) the risk-on sectors are leading the broad markets. With the preponderance of evidence discussed, we believe 2 is more likely as we push into early 2022. 

Why This is Not the End of the Great Bull Market

In one word – liquidity. I've talked about this for several weeks, in various ways. Last week we showed the strange phenomenon that money market funds and the S&P 500 are both close to ATHs, which is one of many examples of the excess liquidity in the markets. This week, we will focus on how the flood of liquidity in the economy is affecting the banking system.

 

I, for one, do believe the central banking system will go down in history as a monumental failure. However, you have to play the market you are dealt – not the one that you want or think makes more sense. Many pundits have stubbornly ignored this reality, and as a result, missed out on one of the greatest bull markets in US history. That being said, this is a FED-driven, liquidity-fueled bull market, and the drastic actions taken by the FED (and global central banks) during the COVID crash last year is why we are continuing to push higher today.

 

In 2008, we saw a gradual tightening that ultimately put in motion the GFC. During this time we saw the first run on banks (and money markets) since the turn of the century. The fear was sudden and caused banks to shut the borrowing window for even qualified companies to refinance their debts. As a result, defaults intensified, and only exacerbated the problem. This liquidity/credit crunch was the primary driver behind the pain experienced in the GFC. 

 

Compared to 2007/2008, last year the FED flooded the economy with excess liquidity that was needed by struggling companies to stay afloat. In other words, they guaranteed that a credit crunch would not happen. this lead to the bizarro world of monthly economic data that literally went off the charts in a negative way, while the stock market kept powering higher. As a result, it's hard to look at the current landscape and see any hint of a liquidity crunch. In fact, the opposite seems to be true. 

 

Liquidity in Banks

 

We tend to see the beginning stages of a liquidity crunch in overnight markets. In other words, if a bank needs additional liquidity to meet their normal business demands, they will borrow this cash from other banks in the overnight markets. If these private banks see trouble on the horizon they tend to not want to participate in overnight loans, pushing the overnight borrowing rate up, and thus making liquidity even harder to come by. This lack of overnight liquidity begins to filter into the banking system and ultimately down into the economy. To combat this free-market phenomenon, the FED created the repurchase agreement program (Repos) to be the lender of last result. In other words, when no private bank wants to take on the counter-party risk of another bank needing cash to operate, the FED steps in.

Prior to the economic slowdowns, we tend to see the FED's repo program tick up, signaling that private banks are not willing to loan into the overnight markets. 

Note how these repo agreements preceded major market events. It's a signal that liquidity is drying up, and this removal of liquidity from the market by the banking system is what ultimately crashes the markets. 

 

Now, let's overlay this metric with inflation expectations (10 yr. breakeven rate) as well as economic growth (PMI – manufacturing).

Note how inflation peaked as did economic growth going into these liquidity crunches. What preceded was sharp bear markets in both instances. Now, note the 2011 and 2015 deep correction periods. We had a deceleration in both economic growth and inflation (much like we're projecting going into 2022), but there was no liquidity crunch. The result was either a sharp and quick selloff (2011), or a correction that was more in time than price (2015) before the bull market resumed. It's important to see that we are not in a similar liquidity crunch today. In fact, the opposite seems to be happening.

 

The FED also has a program designed to address this opposite problem banks can face, and it's called reverse-repo agreements (Reverse-Repos). Banks operate under strict regulations, one of which addresses the maximum amount of cash/credit they are allowed to hold relative to assets. If a bank is close to that limit, it will lend this excess liquidity to other banks for a small overnight rate. However, what happens when most banks are flushed with cash and cannot accept anymore? The FED steps in to be the buyer of last result, exchanging cash for bonds at a minuscule rate. 

 

Today, the reverse repo operation is at record highs. 

In other words, the FED is "borrowing" excess cash from banks on a nightly basis. This is what too much liquidity in the banking system looks like. Now, factor in that the FED is STILL adding ~$60 Billion of QE per month on top of the chart above! 

So, like 2019 and 2008, the economy is starting to slow as inflation is likely about to peak. However, unlike 2008 and 2019 there is tons of liquidity in the system that has to go somewhere, and with the CPI running at 6.8% and likely to move into the 7% region, money markets and bonds are not very attractive. For this single, yet crucial reason, I see 2022's volatility to be more like 2011/2015 – an extended road bump in a much larger bull market, which we want to prepare our readers for.

Remember, the FED and global governments need inflation. It is literally the only way out of the massive debt obligations taken on by governments, aside from a default. the same problem was seen in the post-war 1940's – large increase in money supply as inflation ran hot for over a decade. This allowed the US government to get out from under their war debts, while the stock market went on a multi-decade bull market. This, I believe, is what the FED is trying to do today – get everyone used to higher inflation, so that the US has a shot of unwinding its debt. So, creating a market crash would not be conducive to this end. 

 

Our Game Plan for 2022 and Beyond

 

Going back to our Elliott Wave analysis, if we are completing the 4th wave of the larger 3rd wave, that means that we have the final 5th wave to go. If everything moves as planned, which is always a BIG if, we will bottom into late December, and rally hard into the late January time factor, which is targeting the 4900 regions, at a minimum. We also know that we are in a stagflation/inflation style macro environment, which tends to favor mega-cap growth names. The type of mega-cap growth that is working right now is FAANG and semis. Since our recent entries in NVDA and AMD, we are sitting on 60% gains in just under 2 months, as LRCX and MRVL were almost at ATHs while the rest of tech sold off hard. You are seeing where the money is flowing in real-time. We plan to continue to ride this momentum as the SPX makes its minor 5th wave push, focusing on a potential MSFT play and continued adds to our semis. 

Regarding high beta, we are trending down into the first-time factor, which, as previously stated, I'm expecting to be a low. This should kick off the final minor 5th wave push. Also, even though we are focusing on mega-caps and semis, I do not think risk assets are being completely left for dead on this push, as of now. 

The options market is not as bearish on risk assets now as the popular narrative/Twitter suggests. Note how ARKK is showing negative implied volatility on a 30-day basis based on their recent realized volatility. When this pattern is present at market/asset highs, it's a big warning. However, when we see this closer to market/asset lows, it's a signal that the options market believes the volatility in this asset is likely to reverse. 

 

So, over the short term, our plan is to continue to rotate into lower beta positions, ride any momentum of our higher beta plays (CFLT, VYGVF, ASAN, AFRM, etc), and then build cash along the way. 

Over the longer-term time frame, we plan to have a reasonable cash position to accumulate shares of great companies for when the economic environment clears up and the bull market resumes. Our targeted themes will continue to be semis, as Beth's long-term thesis is starting to really pick up, as well as Cloud. As growth slows and rates move higher, borrowing costs will be affected as will revenue streams. In a slow-growth environment, we tend to see companies address margins in a much more aggressive fashion. We saw this in 2020 regarding cloud. The cloud migration intensified because companies saw that cutting costly IT infrastructure budgets and moving to cloud systems both reduced overhead and made their business more efficient. We believe the same will happen in the current environment. 

 

Arguably, the most cost-effective microtrend is the work-from-home trend. This allows companies to reduce COL allowances as well as expensive real estate. This trend is here to stay, and we are only in the early stages. For this reason, we like plays like ASAN, ZM, MNDY, etc. Regarding Zoom, it showed a 94% enterprise growth on top of triple-digit comps. Yet, the market continuously beats it down as a consumer play that peaked during COVID. This is a mistake and allows for a great chance to buy a quality company at low relative valuations. Though we did not expect the market to beat it down this much, we do believe a relative floor is under Zoom based on its current price to forward growth projections. 

 

Look for ideas like this as we move into 2022. If/when we start approaching any bottom from the coming correction we will shift our focus to more high beat/speculative plays. But, for now, defense is warranted for anyone looking to not be shocked by 2022. As always, we developed a thesis based on incoming data. If that data changes, so will our thesis and pivot. We are not looking to be right, only make money. Markets are fluid, and thus require the need for pivots If anything changes, you will be the first to know. 

Also, it's important to not overreact and sell everything or buy everything in an emotional rush. Instead, we prefer to tilt our portfolio into a defensive/offensive posture. We will target 10-15% cash if our plan for a bounce manifests.

Will Dividend Stocks Become the Inflation Trade?

Posted on by io-fund

Investors were taken by surprise last week when the US consumer price index rose 5.4% year-over-year in June, the fastest pace seen since August 2008. On a monthly basis, it rose 0.9%. Excluding the volatile food and energy prices, while the Core Consumer Price Index rose 4.5% in June, this was the fastest pace since 1991.

Source: YCharts

There is an argument that the recent rise in inflation is temporary. One prime reason is attributed to the supply constraints due to the pandemic. The sudden rise in used cars and trucks accounted for a major portion of the inflation number, and this was mainly due to the global chip shortage, which reduced the supply of new cars. Used cars and trucks rose 10.5% in June from the previous month, when you compare on a yearly basis, prices rose about 45%.

Last week, we discussed in detail technical signals that suggest the market is not currently concerned with inflation. We see this in the new uptrend in bonds and the collapse of certain economically sensitive commodities. The market is shrugging off inflation fears, for now.

You can read our Portfolio Manager’s July Market Update that discusses this in detail here.

We are prepared to shift our investing thesis if the narrative changes. If inflation is not transitory, this reality will show up in price relations first. For example, if bonds continue down while commodities continue up, this could lead to the FED increasing the Fed Fund rate sooner than expected.

Historically, the rise in interest rates has been negative for equities, which ultimately stops the bull market. Some of the possible reasons are when the discount rate increases the present value of future cash flows will be lower. Another reason is that debt servicing costs for companies with high debt will be higher. The exception will be banking stocks which benefit from rising interest rates.

Even if this happens, history tells us that the time to worry is not when the first rate hike happens, but up to 18 months on average after the yield curve inverts. So, even if rates increase ahead of schedule, history tells us that we still have time for the bull market to run.

It’s important to remember that what causes the cascade of events that leads to a bear market, is the FED reacting to rising inflation. So, the sky-high data regarding inflation is nothing to shrug off completely. If inflation numbers do not subside, the FED will have no choice but to raise rates, and we could be looking to invest in an inflationary environment.

Stocks can make solid investments precisely because they beat inflation in the long-term. On a more granular level, the more traditional thinking here is that dividend stocks are ideal during periods of inflation because of the periodic dividend payouts. Dividends also help to fund your increased expenses due to inflation. While growth appreciation stocks are good in the long term, many institutions will see dividend stocks that have reasonable growth as an important hedge. They will also typically view low debt companies with low debt servicing costs as favorable.

Please note: the I/O Fund is a tech growth portfolio that places an emphasis on growth over profits, and for this reason, the I/O Fund does not currently hold stocks for their dividends. Below, we discuss what inflation trades can look like for a more forward-looking discussion.

Dividend Stocks that Institutions Could Favor for an Inflation Trade

Broadcom Inc. (NASDAQ: AVGO) shares rose 50% in the past year. The company’s revenue growth has been strong as it grew at a compound annual growth rate (CAGR) of 16% in the past five years. It also has a very good profit margin which also plays an important role in the long-term stability of dividend payouts.

The company has a dividend yield of 3.00%. It is comfortably above the US 10-year treasury rate of 1.19%. The company has steadily increased its dividends. The free cash flow from which the dividends are paid is also increasing. In the recent earnings call, the company’s CFO, Kirsten Spears mentioned “Relative to capital allocation, first and foremost, we're dedicated to paying 50% of our free cash flows to our shareholders.” In the recent quarter, it had a free cash flow of $3.4 billion and dividends paid were $1.6 billion.

Intel Corp (NASDAQ: INTC) has a dividend yield of 2.45%. The company raised its dividend in January this year. They increased their quarterly dividend by 5.3% to $0.3475/share. The company had a free cash flow of $1.6 billion in the first quarter of the fiscal year 2022. It also had repurchased $2.4 billion of shares and completed the $20 billion repurchase plan announced in October 2019. The management also assured that they are committed to growing its dividend.

Source: YCharts

Will the rise in interest rates be a concern for the ad-tech industry?

Ad-tech stocks typically have low or no debt. One exception is Magnite, which has a debt-to-equity ratio of 1.13. Magnite accumulated debt when it acquired companies in the past year. More recently it acquired SpotX, a deal that will help to double its CTV business. In the words of Michael Barrett, President and Chief Executive Officer, “We believe the combination is transformative because it immediately gives us critical mass and scale in CTV and more than doubles the size of our CTV business”.

Roku has a debt-to-equity ratio of 0.36. The company’s debt is small and it’s coming down. Interest costs were only $742,000 in the recent quarter when compared to $863,000 in the same period last year. Roku’s revenue in the first quarter grew by 79% year-on-year to $574.2 million. It also added 2.4 million incremental active accounts in the quarter to reach 53.6 million. The company had a net profit of $76.3 million when compared to a net loss of $54.6 million in the same period last year.

Source: YCharts

Looking into the stock returns of the ad tech industry, Roku has been outperforming other companies in the past six months. Recently listed companies like PubMatic and Viant Technology had successful initial trading gains but they have not sustained in the recent months.

Secondary Offerings to Raise Cash

After tech’s historic run last year, many companies have benefited from rising stock prices by tapping secondary offerings. Zoom raised $1.75 billion in January this year by pricing 5.15 million shares at $340 per share. It was able to benefit from the strong share price gains due to the remote working boom. The recent offering was about 10 times its IPO price. Previously the company had issued its shares in the IPO at $36 per share in April 2019. Zoom is a debt-free company.

Shopify raised $1.5 billion by offering 1.18 million shares at $1,315 per share in February this year. The company’s share price grew about 175% during the one-year period before the secondary offering. It had benefitted from the shift to online business during the pandemic.

MongoDB recently raised about $889 million by offering 2.5 million shares at $365 per share. The company has a negative debt-to-equity ratio. Its interest expenses are also high, at $3.7 million in the quarter ending April 30 although down from $13.8 million in the previous year. The stock has a three-year return of 510%. 

Source: Ycharts

Conclusion

Many tech companies have low debt right now with many sitting on decent amounts of cash due to raising cash from secondary offerings. The I/O Fund doesn’t own dividend paying stocks as a strategy, per se, yet it’s good to know what kinds of stocks could be favored by institutions should we see inflation haunt the market and consumer spending environment. Specifically, semiconductor companies like Broadcom which continue to have excellent growth and a dividend yield of 3.00% stand out from the list.

 

Last week, the Portfolio Manager from the I/O Fund spelled out his thoughts regarding inflation fears. In summary, the market’s quiet rotation back into growth stocks and bonds, coupled with the new downtrend in commodities and defensive names, seems to suggest that the market isn’t as concerned with inflation as retail is. You can read this article here.here.

Nasdaq100 Levels to Watch for the Next Leg Higher

Posted on by io-fund

Being a contrarian in tech investing has been a rewarding strategy over the last 5 years. Believe it or not, as far back as 2016, the contrarian position in tech was to remain a bull. Each year since, floods of articles presented the popular thesis that the “tech bubble” was about to burst (2016, 2017, 2018, 2019, 2020, 2021).

For those that remained a contrarian, the cumulative returns of the NASDAQ100 since 2016 has been ~ 207% returns. Meanwhile, the average drawdown per year since 2016 was an eye popping 17%, while the average annual return for the year was about 21%.

Only those who ignored the talk of a bubble participated in the epic run that has resulted in the Nasdaq100 driving forward some of the world’s most valuable companies. Which leads to another point: analysts continually and consistently misunderstand tech in the early days of a company’s rise. Using value metrics to build the case for a bubble, these same analysts have gone silent when that bubble refuses to cooperate with soothsayer predictions.

Once again, this year is witnessing a rotation out of tech growth, as more articles claim that this is the actual popping of the tech bubble – for real, this time. Although I do believe the market will experience a true secular bear market at some point in the future, more importantly, I believe the market is setting up first for what appears to be the next leg higher.

I also believe that tech, as well as growth, will resume its lead in the next leg higher. I outline my reasons below.

1) Understanding Tech and What it is Telling us Now

From September of 2019 through January of 2020, the market narrative was that cloud computing was over stretched, resulting in a severe value rotation. At that time, we were hearing that the stocks in this sector had price/sales ratios greater than many of the tech stocks during the dot.com bubble.

A fair representation of these companies can be found in the ETF with the ticker symbol CLOU. This is a pure play on the cloud microtrend and was overweight many of the richly valued tech darlings of the time, such as Zoom, Shopify, Crowdstrike – just to name a few.

Despite cloud being “overstretched” with “dot-com like valuations,” from the February peak to the March low, CLOU saw a 32.94% drawdown, compared with the S&P500 that saw a 35.63%. Also, worth noting, CLOU finished the year up 77.9% while the S&P500 finished the year up 18.4%.

In other words, stocks with little to no earnings, and a price/sales ratio ranging between 20 – 40, provided more protection to investors during the March ’20 bear market than the value oriented broad markets. The reason behind this phenomenon is either ignored or shrugged off as an anomaly; however, understanding why this occurred is the type of information that would help one to identify companies like Amazon and Google in early stages, despite their rich valuations.

Beneath the negative earnings, and price/sales ratios well into the double digits, are powerful microtrends that can scale globally. Beth Kindig of the I/O Fund presciently wrote an article in 2019 stating that Cloud Computing would be a good safe haven in an economic contraction, even with bubble-like valuations.

“My prediction is this may be one of the last cycles when tech is considered less safe than value stocks. As the market will find out (the hard way), cloud software is actually very safe. It is insulated from trade wars and overseas manufacturing issues. It reduces costs for enterprises, which is ideal for a recession.”

Her thesis was simply that the cloud microtrend was still in the middle of its expansion, and the very nature of migrating to the cloud makes enterprises more efficient as well as reduces costly IT overhead, which can help them survive slowing GDP.

Furthermore, we are seeing companies within cloud grow YoY revenues at rates that are historical records. For example, in recent reports: Shopify grew YoY revenue by 110.4%, Zoom by 191.4% (this is after 3 consecutive quarters of greater than 350% growth), Snowflake grew by 110% and Crowdstrike grew by 70%.

All of these companies came in above consensus in the most recent quarter while most raised forward guidance. We are now lapping the most critical quarter for tougher comps from Covid and we think in the next couple of months, the words “tougher comps” will fade from memory as the better term will be “sustained growth.”

2) Technical Signals

Where is the money from growth flowing?

Since the February top in 2021, we have seen a large rotation from growth names into value. Some have posited that the growth trend is over, and the era of value is set to lead. To get a clue as to whether this thesis is correct, I think analyzing the flow of money from tech is key.

On a simple 3-month relative return, which takes us back to the start of the correction, we can see money flowing from high growth sectors and into value sectors.

However, if we dig down a little deeper, the money seems to be flowing into early-mid cycle sectors, such transportation, financials, industrials, materials. The standard late-cycle sectors, such as utilities and consumers staples, appear to be lagging, which suggests that the market is more likely positioning for a move higher than preparing for a protracted drawdown.

I further believe that the market put in an important bottom on May 12th. Below is a chart showing that since the May 12th bottom, quietly, we’re starting to see a rotation back to high growth names, and the selling of value as well as commodities. 

It appears that underneath the moderate price movements in the broad market, we’re beginning to see a rotation back into growth names. We will need to see this trend continue, but so far, if the bottom is in, the up days in the market are suggesting a continuation of growth outperformance.

Breakouts Around the World

Just like in late 2016, we are seeing an abundance of analysts suggesting that the major top is in or we are close. This would be followed by a major and protracted bear market. Also, just like in late 2016, this thesis is not being supported by the price action in major markets around the world.

The above chart illustrates the breakouts we are seeing across the board: Global Blue Chips, Emerging Markets, Europe, India, even Small Caps are showing strength, as is China. These are typically not the intermarket signals we see just prior to a major bear market.

Strong Market Breadth

Market breadth is a technical measurement that measures the number of companies participating in a trend. In other words, if the number of companies that are participating in a broad market uptrend is growing with the market, then this is a healthy uptrend.

On the other hand, leading into most corrections, we see market breadth decreasing while the broad market continues higher. If fewer stocks are holding the markets up, this is typically a bad sign for an uptrend.

We use many methods to measure market breadth, but the simplest and oldest way is the advance decline line. Simply put, this indicator plots the difference between the number of stocks in the market that are increasing in price vs. the ones that are decreasing.

If we compare this indicator to the S&P 500, we can see an instance leading up to the September selloff in 2020 where the advance/decline line was signaling weakness, while the market continued higher. Today, we are not seeing this. In fact, the advance/decline line is breaking out to new highs before the market. This is indicating that more stocks in the market are moving up vs. down, and when we see this indicator breaking out ahead of price, more time than not, price follows.

The NASDAQ100

Most importantly, the NASDAQ100 (NDX) appears to be setting up for a large breakout move.

NDX is approaching a major resistance zone in blue on the chart (between 3800-4080). The upward-trending, zig-zag pattern into this resistance is typically a bullish pattern. Also, note how the price has respected the upward sloping trendline, which is highlighted with the dashed green line. This is also a promising sign, and gives us a clear level to work with regarding any coming weakness.

The Counter Argument

With as many bullish signals as we are getting, the NASDAQ100 must confirm the next leg higher with a breakout above 14080. Tech is simply too important of a sector both in the economy as well as being a large percentage of the broad market. If NDX fails to break out, and instead breaks below major support at 13200, we could see another correction before we can get another shot at a breakout setup.

Also, the transportation index is flashing a potential warning that this breakout could be premature.

 Historically, the transportation index tends to lead the market. Because global commerce relies on transportation, a slowing down in this sector tends to signal a slow-down in the economy. Also, because equities are usually looking ~6 months out, the price of the transportation index can be a strong leading indicator.

As of today, the Dow Jones Transportation Index (DJT) is trending down while the rest of the major indexes are trending up. Because of the tight consolidation, this trend could change in an instant; however, I would not get too concerned unless supports break across the board in the U.S markets.

Supports to watch

Dow Jones Transportation Index – 15250

Dow Jones Industrial Index – 34300

NASDAQ100 – 13200

Regardless of the bullish signals and global breakouts we identified, if the above supports breakdown, we will likely look to hedge our portfolio over the short to intermediate-term time frame. We believe the outlook, as of now, is signaling a higher probability of another leg higher. However, until price agrees with our thesis, the I/O Fund remains cautiously bullish.

The importance of the NASDAQ100, and Levels to Watch

Posted on by io-fund

 Long term technical signals suggest the current selloff is a buying opportunityLong term technical signals suggest the current selloff is a buying opportunity

Coming out of the 2008 Financial Crisis, we saw a shift from value to growth for the first time since the 90s. Growth stocks took the lead and have been the general theme of the current secular bull market that we are in. With a multitude of tech focused microtrends like the internet, mobile, social media, e-commerce, now cloud and soon to be 5G and AI, the tech sector has led growth stocks. 

From a broad market perspective, the NASDAQ100 (NDX), and index of predominantly large cap stocks, has been the most important index to track within the current cycle. It has led the broad market into and out of almost every major correction since this bull market began.  

This pattern has even continued since the quick bear market in March of 2020. From peak to trough, while the S&P 500 saw a 35.40% drawdown, the richly valued NDX only saw a 30.50% drawdown. Since the March 23rd low, we have seen a consistent trend where the NASDAQ100 has led us into each correction and also bottomed before the S&P 500. 

However, since the recent correction began on February 16th, we have seen a meaningful shift from growth to value. Where the DOW is at new highs, the S&P 500 and DOW Transports are down less than 2%, while the NASDAQ100 is still about 7% away from new highs.  

This is a meaningful rotation, which we see as healthy. The microtrends in tech are not over or at the end of their cycle, regardless of stock prices. Also, we want to see as many sectors and stocks participating in this bull market, which is happening. 

Considering the importance of tech’s leadership, as well as the overall weight of tech within the S&P 500, which currently sits at about 24%, without the NASDAQ 100 participating in new highs, I would consider any bottom to be suspect. For this reason, we believe tracking the NASDAQ100 to be crucial right now in order to glean broad market cues. 

I/O Fund has been preparing for a correction since late February. We built up a nice cash position, which we were vocal about with our readers as well as on Twitter (here here here). We also added a series of hedges prior to the selloff, and have recently added them back due to the possibility of a lower low.  As of now, the long-term technical signals, and trend is still up. This suggests the current selloff is a buying opportunity, which we have been taking advantage of. 

NDX: Levels to Watch 

From a technical perspective, there are two scenarios we are tracking:

  1. The correction is over. For the green count in the chart above, we finished the final leg in the March 5th correction. If NDX holds 12,600 and we see a breakout above 13,300, the low is likely in for this correction. To confirm this scenario, we need NDX to breakout above 13,300, at which point our small hedge will come off.
  2. NDX makes a new low. If NDX breaks 12,600, that would put us in the red count. This count has us in the final leg of the correction, with a potential bottom at 11,715 to 12,050. 

Regardless of what path NDX takes, we view this pullback as a buying opportunity and when the correction is complete we expect the uptrend to resume. We have been building key positions as we feel you can’t time the market and you most certainly can’t time a bottom.

There are many tools we use to guide our entries as well as risk management. One is the RSI, which I believe will be a key technical indicator to focus on based on the pattern in the daily chart. The trendline that was acting as support has become strong resistance. NDX needs to break back above the trendline before we can call this correction over. Furthermore, NDX has major support at the blue line. This was the final capitulation point for the March 2020 lows. If NDX reaches that level, we will take it as a strong buy signal. 

Disclaimer: Beth Kindig and the I/O Fund currently owns shares of TSLA. The content in this article is intended to be used for informational purposes only. The author has not received any compensation from any third party or company discussed in this article. The content is the expressed opinions of the author and is intended for educational and research purposes. Any thesis presented is not a guarantee of any particular stock’s future prices, so please factor this risk into your own analysis. It is very important that you do your own analysis before making any investments based on your personal circumstances. The author is not a licensed professional advisor. Please seek counsel form a licensed professional before acting on any analysis expressed in this article, to see if it is appropriate for your personal situation.

 

SPAC Updates: February 26th, 2021

Posted on by io-fund

There is a level of speculation to SPAC investing as the majority of these companies have little or no revenue.  There is an obvious risk to speculating on young companies, which is that they will not be able to meet their future projections.  This is precisely why we choose to allocate a small portion of our portfolio to SPACs, typically not more than 1-2% of our total portfolio in any one company.  We are comfortable adding more to these positions as they grow and as the company begins to successfully execute on its goals.  Until that point, it is important to recognize that we are making speculative investments and the stocks may be extremely volatile.  Keep this in mind when sizing your own positions. 

When evaluating SPACs, we prefer companies with the most upside potential in big, fast growing markets. Below are the companies we think have potential and fit our investment profile.

Lucid Motors (CCIV)

CCIV has fallen sharply since its merger confirmation with Lucid Motors and we took that opportunity to open a position.  This is a company with enormous potential in the coming years.  As of 2020, only 3% of global car sales were electric vehicles.  The EV market is set up for exponential growth this decade and beyond as the world focuses on reducing carbon emissions. 

I discussed why Lucid’s technology is a legitimate competitor to Tesla here.  In Lucid’s Investor Deck, they are projecting 4% market share of the market by 2030.  That number would put them as 8th on the current list of auto manufacturers.  Lucid has been incorrectly characterized by some as a “Tesla Killer” or a company that must outperform Tesla to succeed.  That could not be further from the truth as management is not predicting this nor modeling this. 

Lucid has over 7,000 pre-orders for the Lucid Air Dream that is set to debut in the second half of 2021.  The company has a working manufacturing facility in Arizona that can currently produce up to 34k units per year.  The company is looking to scale that number to 365,000 annual units per year.  They are currently working on building a manufacturing facility in China. 

The Lucid Air Dream has been independently verified for each of its capabilities.  Lucid has over 20M real-world vehicle miles driven.  All OEM racing teams in the world’s premier EV racing series are powered by Lucid battery packs and software.  In its investor presentation, Lucid talked about its plan to expand its technology supplier business beyond the EV racing series with potential applications in aircraft, eVTOL, military, heavy machinery, agriculture, and marine.  Lucid has confirmed that 6 other car companies have contacted them about using their battery technology already.

The Lucid Air has 32 sensors including LIDAR to support Level 2 hands-free highway driving.  The company’s goal is to reach Level 3 hands off and eyes-off capabilities within 3 years, which no automaker currently offers.  Eugene Lee, the senior director of ADAS and autonomous driving at Lucid Motors, formerly worked on GM’s Super Cruise.   

Lucid now has $4.5B in cash on its balance sheet, a number that Tesla did not accumulate until 2019.  Tesla had $106M of cash on it balance sheet when it first IPOed.  Fisker, another EV company that has not yet delivered any cars, has $400M of cash on its balance sheet.  Lucid is also backed by Saudi Arabia’s Public Investment Fund, the country’s premier investing institution.  With a strong balance sheet and heavy backers with lots of cash, Lucid is well positioned to overcome the challenges involved with mass producing cars.    

Lucid management contains 8 former Tesla executives and 3 former Apple executives.  Peter Rawlinson, Lucid’s CEO, was the former Chief Engineer of Tesla and helped design the original Tesla Model S.  Rawlinson believes he’s taken it to a new level with the Lucid Air, beyond what he engineered with the Tesla Model S. 

Lucid is projected to reach nearly $23B in revenue in 2026.  If the company can reach this mark, it could reasonably trade at least 4x above its current ~$48B valuation. 

Source: Lucid Investor Presentation

There are obvious hurdles for Lucid and risks involved with this investment.  However, we are comfortable speculating on Lucid because of its world class technology, accomplished management team, outstanding balance sheet, and large backers.         

Stem Energy (STPK)       

I covered STPK in detail here.  Stem has proven to be a volatile SPAC for us, but we remain bullish on the company’s long-term prospects.  Stem currently has $200M of contracted backlog and over 100% of 2021 revenue locked in from contracts that have already been completed.  There is potential for a big upside surprise on the $147M revenue target this year as the actual number should be closer to $200M.  The company is projecting revenue to grow at an 81% CAGR through 2026.

Source: Stem Investor Presentation            

Partnerships with Apple, Amazon, Google, Facebook, and Walmart represent a backlog of future business that will drive growth for years to come.  Stem’s value is in reducing its client’s electric bills 10-30% without changing the way they operate.  Stem’s product also helps its clients meet their corporate ESG targets, making them eligible for potential government subsidies.

Electricity production is the #2 polluter responsible for 27% of greenhouse gas emissions.  Over 75 countries including the US have committed to net zero emissions by 2050.  Stem management estimated that there is a projected $1.2T in new revenue opportunities for integrated storage that are expected to be deployed by 2050. 

There remains a great deal of untapped potential for energy efficiency improvement through implementation of new technologies.  Stem is ideally positioned to be an industry leader in the energy storage market as more companies follow the path that Apple and Amazon have already taken.    

STPK also stands to benefit from increased investments in the ESG space.  Money managers are facing greater pressure from investors, regulators, and activists to direct capital toward businesses that support a greener future.  Assets that adhere to environmental, social, and governance criteria are projected to exceed $53T by 2025.    

Proterra (ACTC)

I first covered Proterra here.  Proterra continues to prove why they are the leading electric transit bus manufacturer in North America.  This week, Proterra won a 16 year, $169M contract to lease 326 buses in Maryland’s Montgomery County.  This contract is the largest municipal government deal of any kind for buses.  The Washington DC suburb ultimately plans to replace its entire 1,422-bus fleet over the next two decades using Proterra’s electric battery technology. 

It is only a matter of time until other municipalities and cities make the switch to electric transit buses.  Proterra management estimates that its total addressable market in this industry exceeds $260B.  Currently, the company has a market cap of under $5B despite being positioned as North America’s #1 electric transit bus OEM.  Their buses have traveled 16M total miles, significantly leading all competitors.  Proterra also has partnerships in place with BMW, Daimler, Con Edison, and most recently Komatsu to develop all electric construction equipment.

Proterra is projecting revenue to grow from $193M at the end of 2020 to $2.56B by the end of 2025.

Source: Proterra Investor Presentation

Eventually, every form of transportation will need to be electrified.  Proterra has a commanding lead in North America’s electric transit bus industry and the inside track on future contracts.  Jennifer Granholm, the United States Secretary of Energy, formerly held $1M in Proterra stock options and sat on the company’s board prior to being forced to shed any potentially conflicting investments. 

Battery-electricity technology is the future of bus transportation.  We are in the very beginning of a transition to zero-emission electric buses across the country.  Proterra is the industry leader and proved it by winning the nation’s largest municipal government deal for buses.  They are ideally positioned to win more contracts in the future as more cities transition to electric bus transportation.