bd18aad4-63df-4273-86ed-3e074f105d44_Market-Update-October-29th.pdf
Market Update: October 29th
Introduction
The purpose of this market update will be to discuss the current risk in the market, how to protect positions, and to update you on stocks we have covered previously. We will start by looking at the risks involved in the current market to set the proper stage for a reasonable exit strategy. The second section reviews the stocks we have previously covered on our premium site.
There will be situations where great companies are misunderstood by the market – and the opposite, where companies on the decline are over-hyped. Often times, the analysis we release takes some time to play out. Our fundamentals can give you an edge on companies and stock picks; timing the analysis is the next question. In other words, entry and exits should receive equal consideration in this market.
Our goal is not to be right 100% of the time, but rather to make profits. We would rather make money than be right. If we are correct 60% of the time, yet close any positions that hit our stops, and maintain positions that are winning, then we will be profitable. The only way to responsibly do this is to manage risk.
SECTION 1: MANAGING RISK
1.1 The Importance of Price-to-Sales
Warren Buffet recently told his shareholders that earnings, or net income, “are not representative of the business at all.” Buffet is in essence rewording an old Wall Street adage that net income is an opinion, but cash flow is a fact.
Using PE ratios to gauge the value of the market, especially in the era of large buy-back programs, is not as accurate as using a metric like sales. Top line revenue, like free cash flow, cannot be distorted. The problem with using free cash flow to gauge the market is that not all great companies are positive free cash flow, yet the common denominator is they all make sales.
That being said, the Price-to-Sales Ratio (P/S) of the S&P 500 is currently around 2.2. Anything over 1.5 has historically been considered as expensive. It’s worth noting that there are only two other times in history where the broad market was trading above two price-to-sales – in 1929 and in the dot-com era. The current P/S of the broad market has exceeded both of those time frames.
Asset Manager and writer, John Hussman, has done some good work on this subject. In summary, he has proven that anytime the market is trading at such high valuations, the following years of returns have been historically low.
Furthermore, Hussmen recently posted the following chart:
He further claimed that the most overvalued 10% of stocks in 2000 lost 80% of their value in the bear market that followed the 2000 peak. He then claimed that roughly 90% of U.S. equities, according to their price-to-sales ratio, are more expensive right now than they were at the peak of the dot-com bubble.
The implication here is that the bear market we face could be more painful than the 2000-2002 bear market considering the overvaluation is not isolated to just one segment of the market.
1.2 Top Dog Phenomenon
Another point worth noting while we flirt with new highs, was made by Rob Arnott, the founder of fundamental indexing as well as the founder of Research Affiliates. He coined what he calls the “Top Dog” phenomenon. These are companies that have the largest market caps in the world, and what happened to them after they reached this feat.
In short, nearly every time, they had a significant drawdown and continued to perform poorly in the years to come. The below chart shows performance of these top companies leading up to the top spot, and their subsequent performance in the years that follow.
The above graph shows that this phenomenon is not just unique to American markets. Sooner or later, prices start to matter, and the risk of investing in the top companies today is higher than most investors think. To further elucidate this point, here is a list of the top 10 companies in the S&P 500 each decade going back to 1980.
Notice how transient this list is. You will notice we did not recommend Google per our PDF last earnings report in July, and we have not focused on many of these mega-cap companies with the exception of Microsoft. In fact, Beth is particularly bearish on Facebook due to reputation issues and Apple due to mobile saturation. Therefore, we are believers that top dogs are as suspect, if not more, than high-growth smaller companies.
Point being, just because a company has done well in the past, does not mean it will do well in the future. The market is complacent with the top dogs.
1.3 Q3 Rotation
We have talked about the rotation out of growth and into value. If you owned the S&P 500 only, and held it over the last 3 months, you are up. However, if you are heavily weighted in high beta stocks, you are noticing significant losses. This is telling you that money is rotating out of cloud and high growth and into value and defense. When investors get scared and want to prepare for the worst, they sell higher-valuation companies and buy lower-priced ones.
The Leuthold Group did a remarkable piece on this shift, titled “Portraits of a Split Market.” I encourage you to read this to see just how large of a rotation we are seeing. It warrants caution, because we see this rotation preceding all major drawdowns.
SECTION 2: Our Take on the Market
Regarding price-to-sales, it’s worth noting that a single metric cannot be used in a vacuum to make a broad statement in finance. Today’s market is not like the markets of the past. With historically low interest rates, QE programs, and a record margin expansion with corporate companies, and higher than normal Free Cash Flow in modern companies, the extreme that Hussmen is pointing out, may not be as extreme as the image suggests, and shouldn’t be assumed across the board.
For example, Microsoft operates with a 32% profit margin, which is sizable compared to the typical cash-burn tech companies that are hitting the market today. Furthermore, its profits have grown around 20% over the past year, with sales growth of 14%. These metrics aren’t typically what you’d find in a company trading at 8 x sales.
However, even in the most conservative interpretation, there should be caution with current market valuations. The goal is not to ignore the data nor to become overly-confident. We are in unchartered territory. Nobody can tell you exactly how this will end, or when sentiment will shift. The market is historically expensive right now. What we can tell you is that high valuations do not cause bear markets, but they can intensify the velocity.
Some analysts have been calling for the end of the bull market for two years, many others joined in on market crash predictions this year with the inversion of the yield curve.
We do not get involved with market crash predictions. Instead, our service has worked diligently to provide stock picks and entry/exit timing that we feel is pertinent in this market. Admittedly, it’s a little bit like playing dodgeball as we’ve already seen Amazon and Alphabet miss earnings, yet Microsoft and Intel come in strong.
The risks in today’s market should cause one to reflect on their strategy. We could see the market rise 30% from current levels, or retrace 30% from current levels; no one really knows. The historical data presented coupled with the frenetic behavior in the IPO market warrants all investors to take note of a few key points:
(1) Proper position sizing: how much risk are you taking on? When the market is down 0.5% and your portfolio is down 5%, you may want to consider the level of risk you are taking. We personally don’t put more than 5% in a single position during market extremes.
We are not in a buy-and-hold environment for new positions, thus 5% is the maximum for allocation that we personally follow. (We’ve mentioned on the forum that we plan to increase this to 10-15% after a pullback for our top two to three positions).
(2) What’s your exit plan when the market turns? We have stops on our positions, which we follow. Losing 50% in a position requires that position to go up 100% to break even. And, the space we are participating in can see 20% plus losses in after hours – Facebook, Twitter, Grubhub are all examples. Stops prevent catastrophic losses that you can’t recover from. We place stops based on tight support zones, and will move them up as the position increases to protect our gains and minimize risk.
3) How much cash? The most gains will not be made at the top of a market, so having cash if we see a meaningful pullback is important. We are personally at 40% cash right now. Our plan is to play momentum now and build a sold buy-and-hold portfolio to capture the last of the cloud cycle and to get far ahead of momentum on the AI economy.
4) Are you hedged. We provide short ideas as well as long. Uber and Lyft – both of these ideas returned around 30% on the downside from previous ideas. We still believe in all of these companies as hedges for your portfolio. Make sure you have a short position or two. Possibly look into buying long dated puts on weak companies. Think of it as insurance. But, if you do hold a short, we recommend a 25% trailing stop on those positions.
We realize that some of our favorite companies have very high price-to-sales; such is the challenge of tech-specific analysis. The only way either of us have been able to do well in tech no matter the market conditions is with trailing stops.
Many of our best performing tech stocks have lost 50% of their value very quickly. Within 3-6 months, these stocks are in the black, often by triple digits. We work hard to make sure you don’t buy high and sell low – especially with TA on Shopify, Roku, The Trade Desk, etcetera, which fluctuate wildly.
You’ll notice that even though we held some of these positions, we pushed for patience and a lower entry that materialized fairly quickly. We don’t see many premium services provide this level of dedication to guide you for the best possible returns after the portfolio manager or analyst has initiated coverage. Typically, the portfolio manager or analyst continually hypes the stock after initiating a position and/or aggressively raises price targets. This is not our style. We will always strive to guide entry at the lowest price possible, and we believe it will serve our readers especially during a choppy market.
We like bitcoin and Chainlink per our August PDFs. We’ve included updates on these below. We feel it is to your advantage to weigh Beth’s opinion heavier than those who are not from the tech industry on disruptive tech trends and product positioning.
It is nearly impossible to predict futuristic tech trends, and to sift through the noise, if you are not experienced in the tech industry. We saw this with her call on Facebook’s Libra, which was bold to state it would fail the day it launched. China recently announced a strategic move into blockchain, which should not be surprising with Beth’s thesis on bitcoin (i.e. that the pressure would come from overseas). In addition to the PDF on bitcoin and Chainlink, there is additional free analysis on bitcoin from June on her free blog.
SECTION 3:
Technical Analysis of the Market/Game Plan
By Knox Ridley
The game plan, which I’ve highlighted in the prior market update in September, and have slightly updated in this report, is straight forward. Bull markets rarely die in a whimper and high valuations do not prick the bubble. They are usually preceded by euphoric buying that makes no sense in retrospect. There’s a chance the many “market crash” predictions of 2019 are wrong and we have a final push to new highs and beyond.
Recently, we have seen the market pushed to new highs by Staples, Utilities and Semiconductors. In order to sustain this move, and push us beyond, we will need to see growth, specifically tech, resume a leadership role, which we are starting to see.
Not only has tech broken its resistance at $82.50 (IYW), but so has the financial sector and healthcare. These are positive signs for a continued push higher. However, if these levels cannot hold, we could see a reversal. This is something we monitor closely.
Simply using technicals, if the 2725 level is broken, that is a major warning to the long side of the market with potential to reach 3150. If 2600 is broken, I expect the bear case to be more likely, which can see us go much lower (some forecasts call for 2200 if 2600 is broken).
This view has not changed since September; although to the frustration of any technical analyst, we have continued to trade range bound for a sideways market throughout most of 2019. This is why many market forecasts have been wrong this year. We’ve seen little progress in either direction. Fortunately for us, we are not market forecasters and our readers have been able to make gains in small pockets of the market.
Most important, if we close above 3150 in the S&P 500, I will view that as the indication that the final bull push is here, and I will personally allocate more into high beta stocks with very tight stops.
In conclusion, and most importantly, as tech investors, this is not the market that you establish a buy and hold position, in our opinion. This is the market where you play the momentum in the market, with tight stops – i.e. a rules-based and well-defined exit strategy. Please keep this in mind with your positions – check position sizing and exit strategies with your financial advisor well in advance of needing to execute on them.
SECTION 4: Portfolio Updates
Snap:
Fundamentally, Snap is much weaker than during Q2 earnings. The market has not penalized Snap, however, and it’s trading above $14 after breaking this support briefly. If we see Audience Network announced, the company will become much more interesting on a fundamental level.
Roku:
Roku is one of our highest conviction long term plays. Anyone who has followed Beth for a while has made out nicely in this trade. Recently, it appeared to have a blow-off top and then a sharp retrace that found support just above the $96 target zone following our encouragement to not buy at the $160 level and to wait for this retrace. It has since corrected upwards in a 3-wave corrective structure, touched the 61.8% retracement level and then turned down again, and is now testing the 73.2% retrace level at $155. Roku is trading above its 20-day EMA, which lighted in light blue. If it falls below and stays below this level, a new downtrend could occur.
If you want to go long Roku at current prices, I’d recommend a stop at $122.50. Keep in mind, Beth is bullish on Connected TV ads and, as of now, we don’t foresee any negative earnings surprises due to strength of this trend.
The main risk to Roku is market perception. The stock gets rocked with OTT news. My primary target for a buyand-hold position is highlighted in the yellow box on the chart (sub-$90), if you care to be patient. In the meantime, due to Connected TV ads, Roku is a solid momentum play.
Zoom (ZM):
Zoom broke the 61.8% and 78.6% retracements and dipped below our $68 stop. Knox closed the position for a small loss while Beth remained in her position due to her current thesis that cloud is not slowing down this quarter (these published in September on free blog regarding all cloud stocks and in October on MSFT ahead of earnings).
Zoom is now hovering around the 200% extension. In other words, the length of the C-wave is exactly twice the length of the A-wave. This is likely due to Zoom’s lockup period expiring. As long as this level holds, and ZM does not dip below its IPO price, I’ll consider this a deep Wave-2, which can lead to new highs in a Wave-3 push. However, if ZM closes below its all-time low, the structure will become complex and one that I will step aside until a clearer uptrend forms.
You can take a shot at catching the bottom, buy at the current levels, and place a stop just below the low at $59.90. Stay cautious until the RSI breaks 60 and at least one resistance zone is cleared with force.
Uber:
Uber has completed its A-wave down, and is currently in a corrective B wave. I’m expecting this renewed uptrend to end soon and commence the downtrend to the target zone in the yellow box. Keep in mind, even if Lyft comes in strong, Uber’s lock-up is expiring and we expect this to strengthen the short thesis that we put into motion at the IPO. Place a trailing stop on that short at 25% for safety.
Workday:
We are still monitoring Workday as we understand the financial analyst day caused a sell-off. Our original analysis had stated:
“(the) ideal buy-and-hold from technical analysis is in the $142-$140 regions, with a possibility of trading as low as the $120 region. If the earnings report is weaker than expected, I’d see that as a buying opportunity – especially if the price breaks the $172 support and we get a deeper correction.”
At this point, Workday has not chosen a clear direction and has remained between bearish and bullish trends, even with the negative news. If Workday goes to the 50% retracement level, we consider these prices to be a gift, and will be strong buyers.
Beth will be writing a new analysis on Workday ahead of earnings and this will cover the financial analyst day in detail.
Bitcoin:
Bitcoin (BTC) has followed our plan perfectly. It has retraced to the lower end of our target box, around $7400. The chart below speaks volumes to the excitement we have of a possible bottom being in place. As BTC touched the long-term support region of 7430, which coincided with the Fibonacci time zone of 61.8% of the previous uptrend. At this moment, the RSI broke its downtrend, while the Stock/RSI bottomed and turned up.
If you have not taken out a position in BTC, we recommend that you consider this. Above is the long-term chart, and the rough path that we expect BTC to take to all new highs and beyond. BTC is known for extending, and the below chart is a very vanilla, no extension 5 -wave uptrend. As you can see, there is a lot of meat on this bone.
You have not missed the move, it’s just beginning. But, please keep in mind that this is Bitcoin – it’s extremely volatile, known for major extensions, and can reverse on a dime. So, maintain reasonable position sizes. We are not putting in more than 3-5% of a portfolio in BTC, at most. The new stop for BTC is $7500. If it closes below this price, sell and we will regroup. We firmly believe any small losses will be made up on a trend reversal and the goal will be to not miss out on the uptrend.
ChainLink:
Link has also followed our trading plan quite well. It traded into the middle of our target zone – around $1.75 to $1.50, and then shot above the $2 resistance. It’s now trading around $2.75 in a clear 5 wave pattern. We see Link as just beginning its uptrend as well, and we see new highs and beyond as a strong possibility. Link is a high conviction choice. If you start a position now, place a stop just below the $2 region.
BABA:
Trading within the large degree triangle pattern, both on the RSI and the price. It should be due for a sharp move once this pattern is broken. Stop remains just below $146. This stock is fundamentally stronger at the current valuation than it’s peers and has a reasonable probability of doing well in the near term.
Telaria:
Telaria is up about 4% so far. Stop remains just below just below $5.75. This stock is a small cap Connected TV ads play with a low valuation headed into earnings. We believe there is room in this price.
Pinterest:
We like Pinterest more than its peers and believe there’s a reasonable probability of the company reporting strong growth into the near future. This PDF was released last week. We believe the market will reward Pinterest in either this quarter or next quarter for its consistent revenue growth.
Shopify:
This stock has seen continued volatility and corrections since our last report. Last week, it was trading back at support around $290. The large degree head and shoulders pattern is still in play. Below $280, and it will be confirmed. If you want to go long, keep this price point in mind for a stop. We believe Shopify’s strategy to serve the merchants, and improve their process, will help the company compete with eBay and Amazon.
Mongo DB:
This stock has continued its downtrend and is currently trading within our original target box. We had stated in the PDF that the more likely scenario is that MongoDB will break support at $141 and allow for an entry between $95 and $128.
The red circles are showing a positive reversal signal, which is telling me that the selling in MDB may be slowing down, and it’s due for at minimum a short-term reversal. It’s holding at a key support level – 23.6% retracement and 200% extension. If this level breaks, expect it to find support at the 38.2% retracement around $85.
One scenario to consider if you want to attempt to catch the bottom, is to go long today as the stock has a reasonable probability of reversing, and place a stop just below the 23.6% retracement level at $114.
Microsoft:
We recently published quite a bit of information on Microsoft ahead of earnings as part of the thesis that cloud is not likely to slow down this quarter. The company went on to win the Pentagon contract, which was nice timing for our readers. Notably, Beth predicted MSFT would win the Pentagon contract in December of 2018 when only IBM, Oracle and Amazon were being considered due to Microsoft not having the correct security clearance. You can find this prediction on her free blog.