Last Friday, we decided to log gains in both NVDA and AMD, while keeping NFLX on hold. We logged a 24.45% gain in NVDA and a 20.78% gain in AMD. Our conviction on NVDA and AMD is as high as any stocks we’ve covered in our service, so it may seem odd that we are closing these positions today.
The simple explanation was best expressed by the famous investor, Howard Marks, when he stated, “It’s not what you buy, it’s what you pay for it that determines whether something is a good investment.” Because of the current macro environment, coupled with stretched valuations in both stocks, we believe that we will be able to get much better prices in the coming months. In order to confirm a return to good times, we would like to see favorable price action in the markets, a new liquidity cycle start in the economy, and avoiding the looming credit cycle. As of now, all three of these factors are not suggesting a new bull market is starting.
On December 30th, we alerted our readers to the strength in the semiconductor sector. We stated that, “we believe that semiconductor stocks are signaling that they are ready to resume their leadership role going into 2023.” Since then, not only was the semiconductor sector the strongest tech sector, but it has turned out to be one of the best places to invest in for 2023.
This call has proven to be very timely, both as a general theme and in how we decided to play this trend. Our starting cost basis in NVDA was $212.65 on 2/11/23, and $76.37 for AMD on 11/15/22. However, in our premium service, we have a much lower cost basis in both. We started buying NVDA at $108.51 on October 13th, while our starting cost basis for AMD was $57.34 the day after.
We mention this to our readers because we believe that through our process, we can help navigate when to add/trim/sell/start a position in great tech stocks. Our goal is to own great companies at great prices for the long-haul. However, we believe the time to get defensive is a prudent position to take for following three macro reasons:
The Market Price Action Is Risky
The structure of the broad market since the October low is a clear 3 wave bounce. This is a risky structure, as it tends to suggest we are in a corrective bounce in a larger downtrend. Since February, we have seen many major banks stocks suggest a top is in, while many tech names appear to be putting in a topping pattern. Our primary case is that the broad market tops out over the next couple of weeks/months, and begins its push towards the 3000 level SPX. There is a chance that we see a push to new highs first, but it is uncertain whether that happens or not.
Note in the above chart the Relative Strength Index (RSI) below the price chart. This is a momentum indicator that produces very important patterns. Note how the post-COVID bull market held the black trendline as support. It then broke this support, which has been resistance in the following bear market. As of now, we are not seeing internal momentum that is suggesting a new bull market is developing. This is a further warning to the bulls, as the technical picture is not as healthy as some make it out to be.
Discount Window Borrowing Is Not a New Liquidity Cycle
Liquidity can be measured in the economy based on the Federal Reserve’s Policies as well as the Treasury’s general account balance. When you measure the liquidity in the economy against the S&P 500, you can see a clear correlation between the two.
As the FED starts a new liquidity cycle (black line going up), stocks eventually follow. Some may be encouraged by the sudden rise in the FED’s balance sheet as a sign that a new liquidity cycle is starting. This assumption would be a mistake.
Yes, the FED’s balance sheet expanded, but the FED’s balance sheet consists of many facets beyond quantitative easing (QE). In QE, the FED actively seeks out to buy long-duration bonds in exchange for bank deposits (not money). Their intention is to control the yield curve on the long end, to encourage economic activity, and it is an intentional action.
The part of the balance sheet that just expanded is what's called primary credit, or short term loans through the FED's Discount Window. The Discount Window is one of the FED's original purposes – to be the lender of last resort to banks that need liquidity now. This is a stigma for banks when they have to use it, because it means they are in dire straits and desperately need liquidity to maintain daily operations. These loans must be backed by collateral and have a very high yield that must be paid, which is about 4.6% right now. This is very expensive money that no bank takes unless it's absolutely necessary.
That being said, if we isolate the part of the FED's balance sheet that is primary credit, here is what we get.
These are expensive loans that banks do not want to hang onto for long. So, they typically get paid back quickly. Also, note when these spikes happen, and it is not during good times. They are the result of liquidity drying up and banks needing expensive injections to survive daily operations. The largest bump in weekly primary credit happened a few weeks ago – $152B vs. the prior high in 2008 at $111B.
Most importantly, we can see that during the same time the FED continued to engage in quantitative tightening (QT) while continuing to raise rates. Even though banks are taping the Discount Window, the FED is practicing restrictive monetary policy, and thus not starting a new liquidity cycle.
Don’t Forget About the Credit Cycle
It has been nearly 14 years since we have experienced a true credit cycle, so many investors have not experienced one. Due to low inflation, the FED has been able to flood the markets with liquidity in several periods of weakness, allowing the economy to avert a credit cycle. This resulted in relatively short, while sometimes deep, corrections that were bought up quickly.
However, due to inflation being at a 40 year high, the FED does not have this convenience anymore. They have thus engaged in one of the most aggressive rate hiking cycles we’ve seen since the 1970s.
What many forget is that rate hikes cause damage to the economy, and by some measures, it can take up to a year for those rate hikes to actually effect the economy. The bulls are betting that the rate hikes that are still happening, will somehow not affect the economy in a material way, which history does not support.
In the chart below, I compare the Fed Funds Rate (BLUE) to the S&P 500. The below gray bars show the lending standards for banks. As banks get more concerned about the economy, the less loans they provide, causing a cascade of defaults.
Note how the FED starts a new liquidity cycle usually around the top in equity markets. They start lowering rates, knowing that it will also take time for these lower rates to filter into the economy. However, once rates go up too high, the damage is done, and the economy as well as the markets must go through a credit cycle before a new expansion period can start. What’s concerning is that the FED is still hiking rates, meaning that this credit cycle could take longer to cycle through than most think.
In conclusion, bull markets do not happen in vacuums. They require expanding credit and expanding liquidity, both of which are not happening now. The price action in the broad market is also not favorable to the bulls, which has us playing defense. NVDA is up over 150% off its low, while AMD is up over 75% off its low. These two, at best, are due for a pullback. But, considering the macro environment, we believe taking gains now will provide us more cash to buy these great stocks lower in the coming months.