The Market Crash

The hypothesis I've come to develop and future outlook for stocks

This price action is very similar to the 2018 market sell off, but, history doesn’t always repeat. It rhymes. Let’s talk about where we are today by putting perspective on the lessons learned from the past, analyze charts & market indicators, and figure out where we will likely go in the future. This can be helpful to figure out a game plan for your portfolio in the weeks and months ahead.

Market Disparity & Why This is Happening

First, we have to talk about the “why” behind this sell off and a few very important indicators we should be paying attention to. The reason why we should do this; so we can put the correct context behind this sell off rather than tying it to the “Omicron” variant, which the media loves to tie all volatility to. The first place to look is going to be in the niche’ areas of the market and truly understand the overall “breadth” of the underlying market below the major indices.

The chart above is saying that approximately 25.75% of stocks in the NASDAQ is currently trading above the 200 day moving average. By historical standards, this puts it in line with some of the most aggressive corrections in years past; which include the 2015 market crash, 2018 market crash, and the 2020 Corona Virus lock-down related crash. This is extremely significant because another figure tells a completely different story.

Notice first that the first chart mentions the entire index and the second chart, which is directly above this writing, shows the NASDAQ 100. The NASDAQ 100 is the 100 largest companies in the NASDAQ.

If you isolate just the NASDAQ 100, it only shows approximately 53% of companies are trading below their 200 day moving average! This is normal and hardly even a causation for panic. This disparity has led to absolute confusion in the financial markets, leaving many investors to wonder what in the world is going on. Why are the major indices showing a minor blip, when many of our portfolios tell a different story?

The reason why is directly related to what the Fed is doing and what has happened recently when Jerome Powell testified to congress about 2 weeks ago. During the meeting, he startled markets coming out with a more hawkish tone (the markets aren’t used to this) hinting at a more aggressive taper and monetary policy. He mentioned he may need to speed up tapering expectations and some fed members have brought up discussion about aggressive rate hikes in order to control supply chain related inflation.

This instantly sent '“riskier” stocks into Bear Market territory. As depicted by the image above, you can see that Large Caps remain relatively un-phased while mid-caps are now at pre-pandemic multiples. Small Caps, which are considered “riskier” despite underlying business fundamentals, are now equivalent to 2018 market lows and have surpassed 2015 & 2016 market crashes. In other words, we are now reaching an extreme territory when it comes to the bifurcation in the markets. Large caps and small caps haven’t seen a difference like this since the 1999 market top.

Let me emphasize that I do not think that the same thing will happen, where we lead to a blow off top, but I do think that what comes next may be less predictable than investors think.

In summary, the reason why this is happening is that the markets are most likely very uncertain. Institutions and investors alike are rushing toward “safe haven” stocks, which is pushing up the price, and selling anything with even the slightest bit of forward value priced into a share price. Many investors are completely ignoring valuation and business fundamentals based on a future outlook of the Fed that may not even happen! The fear is driven by the idea of less liquidity and raised interest rates, which will certainly lead to head winds in long-duration assets. Unfortunately, all these stocks are being clumped in together. Markets tend to over shoot moves both upward and downward.

There’s a Chance the Fed Back Peddles Like They Did in December 2018

This is where things get interesting. When we look at the Bond Market, it tells a different story than what the headlines are telling us. Let’s recap what has happened recently:

1. Omicron, a COVID variant, spiking policy response fears in the market. Currently we’ve seen aggressive positions by a few countries, trying to prevent this spread. It is important to know that the market all but shook off the Delta variant after a few trading days. This means that this is likely not the sole cause for market weakness.

2. J-Pow retired the word “transitory” when speaking of inflation and came out with a more hawkish tone. In addition, markets began pricing in 2 rates hikes (maybe 3) for 2022 and tapering to be expedited from $15B/month to $30B/month. Basically, the outlook for hawkish Fed policy came more in view for 2022

3. Supply chain constraints have officially been reported as “improving” and is likely to only persist for the next few months. In addition, Black Friday and Cyber Monday sales DECLINED on a year over year basis. This is a big deal, let me elaborate more.

Many of the inflation issues we have had have been the results of a “COVID” hang-over and excessive consumer demand. Since demand was so high, supply-chain’s can’t keep up. However, since the supply chain is improving and consumer demand is falling, this is likely telling us that inflation is possibly transitory and that two major factors driving inflation are likely to abate in the following months.

Nobody in the markets appear to be actually asking, “what if JPOW was right all along?”

The Bond Market is Telling Us Something Different

What has been most interesting is how the Bond Market have responded during all of this. When looking at short term Treasury Yields vs long term Treasury Yields, it’s telling us an alarming story that investors and business owners alike should be aware of.

10 year yield minus 2 year yield spread

30 year yield minus 5 year yield spread

Essentially the Bond Market is telling us a few things when you look at the spreads between short term treasuries vs long term treasuries:

• Economic slow down appears probable, possibly recession

• Rate hikes may not happen or will stay low for the long term

• We could see a deflationary event within the coming months

If you look at the spread between the 2 year yield and the 10 year yield, this has been an absolute PUKE of the 2 year treasury yield since Jerome Powell’s comments on expedited tapering. This began on November 29th, the same day J-Pow decided to retire the word transitory.

What This All Means and What Could Happen

The market did NOT like what Jerome Powell had to say about faster than expected tapering. The Stock Market began to fall and the Bond Market is telling us that we’re likely to experience deflation or an economic slowdown (possibly both). This could be telling us that inflation is transitory and that taking away the punch bowl could have negative effects.

Assuming the philosophy that “the tail wags the Dog”, (meaning the market tells JPow what to do/think) and assuming JPow does the right thing, he may back peddle his previous hawkish comments. If he back peddles and changes policy to be more accommodative, long duration assets will show a quick reversal just like 2018.

On December 19th, 2018 JPOW announced that they plan on decreasing rate hikes from 3 down to 2. It is important to know that in 2019, they did not hike rates at all and actually decreased the Federal Funds rate. Following this announcement, Options Expiration took place on December 21st, 2018. The market bottom in 2018 was on December 24th, 2018.

The reason why I bring up options expiration in an otherwise Macro centered news letter is that the past two market crashes have bottom within 2 days of “Options Expiration”.

In Summary

We could see a rapid reversal, much like December 2018, assuming this hypothesis is correct. The reversal may be the result of the Fed back peddling previous comments to a more accommodative approach. In 2018, there were many stocks that quickly reversed during the sell off and went on to reach all time highs. A few examples:

The Trade Desk - traded sideways and quickly went back to all time highs

Roku - fell from $76 down to $26, quickly reversing to all time highs a few months later

Shopify - Traded sideways all year and finally bottomed in 2018 market lows, quickly going back up to all time highs

Conclusion

Knowing this is predominately driven by FEAR of the future and assuming that the Fed just did a “pressure test” on the markets to see how they would respond, it would appear that this correction will be short lived when the Fed inevitably back peddles hawkish statements. By short, I mean that it most likely wont be the start of a secular Bear Market and that the secular Bull still has legs to keep moving forward.

I would assume that the market that will emerge from this one will drastically benefit long duration, profitable, assets, contrary to popular opinion! The only reason I say this is that value investors are beginning to look at growth stocks as “interesting valuations”. Keep in mind, many of the stocks I talk about and many that we own as retail investors are profitable! This means that they do have a P/E, forward P/E, and a PEG ratio. They are being bundled in with all growth by major institutions and being beaten down. At a point, there really is no reason or rationale for this price action for promising long term companies.

Stocks that are growing unprofitably, that depend on excess liquidity to keep growing, may experience further headwind in their share price. This means that us, as investors, should be cautious about where we put our money but not to abandon growth all together. A few profitable growth stocks one could consider would be:

• UPST

• GLBE

• DLO

• INMD

• CRWD

• FB

• ZI

• SI

• APPS, and much more!

Make sure to pay attention to gross margins, operating margins, EBITDA, net income, cash on the balance sheet, and debt. All of these factors will certainly impact the share price of long term investments. Higher interest debt will certainly inhibit growth of certain stocks and impact the top/bottom line of many companies.

I will keep you guys all updated on many of my research findings in the days/weeks to come. Currently, I am watching price action very carefully prior to any major portfolio adjustments/moves. We could see a bottom in the days/weeks ahead but I don’t know exactly when this will be, nobody does.

Stay tuned, stay classy traders,

Dillon