Moving From Fully Invested And Bullish To Neutral And 40% Cash

On almost a daily basis, on both SA and throughout the broader financial news, we are bombarded with market predictions. Opinions tend to be very strong and can be polar opposite, as smart people, all looking at the same data, can draw dramatically divergent opinions. Moreover, it has become a cottage industry to try and predict where the overall market is going tomorrow, next week, and next month.

And yet, some of the world’s best stock pickers, such as Warren Buffett have more or less said it’s a fool’s errand to try and predict the overall market. That said, Berkshire Hathaway almost always has an excess level of cash from its operating companies, as Sir Warren, arguably the greatest allocator of capital of all time, puts that excess capital to work based on a number of factors. So we can gauge his sentiment based on his cash balances as it reflects whether Sir Warren is finding attractive places to deploy Berkshire’s excess capital. With few exceptions, though, Sir Warren doesn’t get overly concerned with predicting the broader stock market per se.

For another example, Peter Lynch arguably had the best Joe DiMaggio investment hit streak of all-time. During this tenure running Magellan, at Fidelity, he delivered average annual returns of 29% from 1977-1990, while beating the S&P 500 11 out of 13 times, over that stretch of time.

When asked about predicting the overall stock market, perhaps Peter Lynch said it best:

If You Spend 13 Minutes A Year On Economics, You’ve Wasted 10 Minutes. (Peter Lynch)

So as someone who has been obsessively following markets and trying to figure out businesses for north of twenty years, both formally and informally, I don’t make a lot of market predictions and don’t write much on the macro drivers.

This year, though, at least through the first half of 2022, was one of the few years where understanding and appreciating the macro risks was most critical. And as every reader should be acutely aware, the stock market had its worst first half performance, using the S&P 500 as our proxy, since 1970.

A lot of really smart people and investors experienced big drawdowns as the selling was so intense. This includes a number of hedge fund managers with long tenures and solid track records of delivering alpha.

Moreover, just like some of these really smart hedge fund investors, I too was caught off-guard, as I just lacked the imagination to believe the Nasdaq would go down 32.5% and Russell down 27%, at the depths of June 2022.

That said, as the famous philosopher, Epictetus, once said:

Circumstances don’t make the man, they only reveal him to himself.

So although, at least ordinarily, I don’t try and predict markets, Q2 2022 was an extraordinary time and this meant zooming out and spending less time in the weeds trying to figure out businesses or a sector and trying to work out the macro.

As the proof is always in the puddling, I want to draw readers’ attention to three macro oriented articles I shared on the free site.

If you take the time to go back and read all three pieces, you might realize those were extraordinarily valuable pieces of work that were way more on point than the vast majority of stuff published by some of Wall Street’s most highly paid, highly visible, and top strategists.

If you are intellectually curious, you might consider taking a look at the thought process contained within all three pieces and the timeliness of all three articles. As most commodity stocks experienced very sharp drawdowns very soon after that April 25th article was published. And, at least as of August 4, 2022, we have had a fierce bear market rally, with the Nasdaq up 20.4% and Russell 2000 up 16.1%, respectively, from the year-to-date lows.

Again, just to be clear, I’m not a macro author, and I don’t try and predict the stock market on a daily, weekly, or monthly basis. That said, I live and breathe the market on a daily basis, and I’m just as engaged as some of the world’s most highly paid hedge fund managers. Therefore, when I do write a piece calling the ‘top’ in commodities or saying I’m super bullish, as a contrarian, on stocks, and here’s why, it is probably well worth a reader’ time to at least read it and consider the thought process.

In A Nutshell, What Happened

If you were to ask me what drove the fierce rallies, I would say the following: Outside of an exogenous shock from Russia, and God forbid that doesn’t happen, the biggest risk was the 10YR spiking. Notice how the market lows almost coincided perfectly with the 10YR spiking to 3.48%, on June 14th and yet the market bottomed on June 16th, as the 10YR receded. As of this morning, the 10YR is trading at 2.70%, as the Fed, although very late to the party, has arrived and the medicine, although potent, will save the patient.

Secondly, sentiment is a major driver of markets, and I as aptly captured in ‘Dangerously Close’ (Part 2), a lot of big and influential hedge funds were on the record as very bearish and super short. Many of these hedge funds love to talk their books and were out and about making the rounds on major TV financial networks and through all facets of the financial press, saying the ‘Sky is Falling’. That was a good barometer, showcasing just how extreme the bearishness reached in mid to late June 2022. And the VIX is another important tool to gauge fear. Incidentally, at or around the time of the Russian invasion of Ukraine, the VIX spiked as high as 39. As of today, it is trading at 22.

Thirdly, the most important piece of the economy is the job market. The job market has been extremely strong and almost anyone that wants a job can find a job. No question inflation is really nasty, notably for folks on the bottom half of the economic ladder, as they have less savings and disposable income, therefore, if the family’s median income is say $100K and their wages are only rising 4% and inflation is 9% then they lost $5K in purchasing power, at least this year. Now, this is really bad from a sentiment perspective, as consumers see the higher prices on a daily basis– at the gas station, at the supermarket, when they are buying goods or services, hence why the University of Michigan data was the lowest reading ever in June 2022. However, if you take a step back, losing $5K of family purchasing is lousy, but losing the $100K of family income is catastrophic. Think about it, unemployment gets capped at a low level (say up to 50% or 60% of salary, at a certain level) and only lasts for a certain period of time, to help workers get back on their feet. Therefore, the monthly cash burn rate is so much higher if a family experiences one or two job losses.

And lastly, and the WSJ did some good reporting on this topic, there is $18 trillion of savings in the U.S., meaning money market, savings, and checking accounts, etc. Therefore, given this huge amount of savings, there was a natural shock absorber to cushion the highest inflation in 41 years.

I’ve Moved From 100% Fully Invested To 35% to 40% Of Cash

Although some of the most engaged, thoughtful and astute readers might like to go back in time and reference when authors write certain things and most importantly understand an author’s thought process and then compare the events on the ground. This way, they can gauge an author’s ability to think and perhaps this can be a decent predictor of an author’s ability to generate alpha, as after all, the name of the website is ‘Seeking Alpha’. That said, for the vast majority of readers, ‘I get it’, their only interest is what happens next.

So just to be clear, over the past five business days, I have been aggressively raising cash. As recently as two weeks ago, I was nearly 100% fully invested. And I was nearly 100% invested throughout June 2022 and most of July 2022. As I expressed in the Dangerously Close pieces, as a contrarian, I was super bullish on the market, as the sentiment was so extraordinarily negative and yet the backdrop was bad, but nothing like late 2008/2009.

I do think we are in a recession and that it is unknowable how the consumer responds in the fall, in terms of their spending and as we move through summer. Many of the conference calls have been pretty sanguine, notably Bank of America’s commentary on the consumer. Secondly, the data and spending patterns expressed by the airlines and travel companies is refreshing, as it does indicate the consumers have some willingness and ability to spend and enjoy live. So, on balance, the consumer is still spending, but they are spending differently than during Covid, much more so on experiences such as travel, as the overhang from two years of Covid have created a condition to live life again.

Tactically, over the past few months, I have aggressively scaled out of most of my retail stocks. Earlier in the week, in fact, this included selling all of my Crocs, Inc. (CROX), in the low to mid $70s, as this was one of my top holdings (sized at 15%). Retail is getting crushed on both sides, as consumer demand and purchasing power is less due to inflation. And retail companies still have elevated ocean freight, inbound and outbound logistics, and finding and retaining workers, both in store and in DCs, remains difficult and more expensive. As you can see, the operating margins of so many retailers have gotten dinged. That said, I keep an open mind and will wait for the data and more information to come in. Tactically, I will still remain opportunistically, albeit selectively, to tactically trade dislocated retail stocks.

Simply put, the market has had an epic rally off the mid June 2022 lows. I was fully invested then. Now, however, I’m up to 35% to 40% cash and being very selective with how I deploy that fresh powder. No question, God forbid there is another military conflict with Russia or the situation in Taiwan gets worse (Nancy Pelosi’s visit sure didn’t help), but the bottom is in. That said, I think this is a bear market rally.

Volatility notwithstanding, I look forward to the day were we can get back to stock picking and spending less time worrying about the macro. Until then, it has been a great and highly lucrative rally, but I raised a bunch of dry powder.