Market Commentary:
Summary of our views is as follows:
• The price of money is a significant driver of asset prices and economic activity. This has been the largest, fastest increase in rates ever in the US. The full impacts show up with a lag.
• The distribution of potential outcomes in many markets is wide, and much wider than it has been in decades. We caution using a lens from the 2000 – 2021 period as a mechanism to evaluate the markets today.
• While inflation is clearly declining, we doubt it will return to the very low levels targeted by the Federal Reserve anytime soon. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed. It is quite uncertain what the Fed’s response will be if inflation only declines to 4% and remains there. Will the Fed keep target rates higher for longer, or will they blink as the markets expect?
• The fed is effectively selling call options on the equity market. They recognize the wealth effect is their most powerful tool. Keeping the markets down should result in consumers feeling less wealthy, and that should decrease demand for goods and services.
• From 1968-82 the equity market went nowhere, and 70% of purchasing power was lost to inflation. We could see a 1-3 year mini period that is similar -> sideways markets and steady erosion of purchasing power. If so, active management should generate far better risk reward than buy and hold in equity indices.
• There seems to be no demand for downside protection in the equity markets. Put option skew is at the lows. Market liquidity has been on a general downtrend. Don’t under-estimate the potential for either a grind lower or a gap lower in equity indices at some point in 2023.
• The mark-to-market of private assets into the new year could be an additional drag. Many will show losses, which may result in less ongoing demand, and possibly a desire to pair back exposure. This all brings elevated risk to public and private equities.
The Federal Reserve’s Operation Break Sh*t continues. Higher rates, and balance sheet reduction impacts are percolating their way through the economy….and although some economic statistics appear to be rolling over, in our view, nothing has come close to breaking yet.
Equity markets remain in a downtrend.
Here is a table of the various “trend” indicators that we like to monitor on a variety of equity indices. Quite a sea of red.
Anyone with teenage kids has probably told them to come home at a reasonable hour because “nothing good ever happens after midnight!” Well, in our view, nothing good happens in equity markets when they are in downtrends!
The “too big to fail” financial service firms have published their 2023 year end forecasts for the S&P 500. Predictions we have seen range from 3900 to 4200. We have been asked for our prediction and responded that it seems silly to attempt to forecast the equity markets 1 year out. One of our portfolio construction principles is:
Portfolio Management is a Probability Game, and not a Prediction Game. No institution has an ability to consistently predict market direction.
We find investor sentiment and expectations more interesting than price predictions.
Investors have transitioned their obsession from inflation to recession, and it appears the consensus is quite confident in a recession in 2023, resulting in a weak first half in markets, followed by a much stronger second half. Queue the famous quote by Rudi Dornbusch that said, “in economics things take longer to happen than you think they will, and then they happen faster than they thought they could.”
What if the economy simply muddles along for a while, and it takes much longer for households to burn through their 1.5 trillion of savings as J.P. Morgan CEO Jamie Dimon referenced back in early December? Do we get a relief rally in equities early in 2023 which revives animal spirits only to then have a much weaker second half which inflicts even more pain? We haven’t heard anyone talking about that sort of scenario.
The equity options markets indicate a setup for another rally in the near term. According to our friends at Spot Gamma, the January 2023 expiration is quite put heavy which has historically been fuel for a rally coming out of the monthly expiration. They also speak of the potential theme of FOMO among portfolio managers who are concerned about missing the right tail (gap higher in equities) more than the left tail risks (decline in equities) and thus are biased to own long call options in order to add in some upside asymmetry to their books. If this long call options flow gets large enough, look for the augmented volatility to continue as dealers hedge the negative
gamma in those options through buying into rallies and selling into selloffs. This also could bring more of the stocks up & VIX up relative price action like we have seen a bit recently.
One of our favorite outcomes of the quieter markets in December (in theory at least) is that so many market participants take time to step away from the screens an write some really thoughtful pieces. Here are two of them that we found worthy of sharing:
OAKTREE: Sea Change
Link: sea-change.pdf (oaktreecapital.com)
Howard Marks discusses why investment strategies that worked best over the past 13 years (or longer) may not be the ones that outperform in the years ahead. We have held this same view and mentioned it in our publications multiple times in 2022, but that is not what is relevant here. What we find interesting is that we still hear from so many individual investors that strongly believe that nothing has changed, that the Fed will pivot and cut rates soon, the money printing press will be turned back on, inflation will return back to low enough levels to be inconsequential, and the same high growth stocks that performed best will again emerge as the leaders.
THE AMBRUS GROUP: Is the VIX becoming Increasingly Leptokurtic Due to the Changing Derivatives Market? Link: https://www.ambrusgroup.com/research
The Ambrus Group consistently publishes some really solid content around tail hedging and portfolio protection strategies. Don’t let the title of the publication scare you – the paper isn’t only for the propeller heads.
Ambrus discusses why market liquidity can evaporate faster than it ever has before. While there has been a sustained increase in options trading, what is more relevant is that the options market makers are now a smaller, more concentrated group of firms. Two-way flow is healthy for markets, especially when it is driven by a wide mix of market participants and not just by a few programs or institutions. During times of extreme market stress electronic traders can disappear, leading to illiquid markets. Ambrus believes that although volatility has remained relatively muted, the tails in the VIX complex continue to get fatter as the derivatives ecosystem changes. We agree.
As we have often said, our exposure to long volatility strategies remains at the high end of our stated ranges in portfolios. The price of protection is cheap on a historical basis (skew), and the distribution of potential market outcomes is wide. We firmly believe every portfolio should have something that is expected to work in another leg lower in equity markets, even if that isn’t the investor’s base case.
Monthly Podcast Recommendation:
We love to listen to podcasts. At the gym. While trimming the hedges. While running on the beach. This month’s recommendation is one that anyone can benefit from.
The Meb Faber Show. Episode #460. Interview with Louisa Nicola. How to perform at your best physically & mentally. 12/21/2022.
Links:
For Apple Users:
The Meb Faber Show: Louisa Nicola – How To Perform At Your Best Physically & Mentally | #460 on Apple Podcasts
Stitcher Link (my go to podcast source):
The Meb Faber Show - Louisa Nicola – How To Perform At Your Best Physically & Mentally | #460 on Stitcher
STRATEGY COMMENTARY:
As a reminder, our Sundial Dynamic All-Weather Portfolios attempt to achieve positive returns regardless of the macroeconomic regime, such as positive or negative growth, or an inflationary or deflationary environment.
This is achieved through a few key principles:
• Utilize multiple asset classes and strategies, beyond traditional equity and fixed income markets • Utilize both active (tactical) and passive (buy and hold) strategies
• Recognize that some investments are stability seeking (short volatility bias) and others are instability or dislocation seeking (long volatility bias) and it is critical that a portfolio contains both.
The desired result is a portfolio of non-correlated revenue streams, that exhibits attractive asymmetry through tactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive in constructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: Our multiple tactical equity strategies generally transitioned from being long the equity markets to cash roughly a year ago. After being mostly in cash for much of 2022, these strategies have started to re-engage in idiosyncratic opportunities on a selective basis. This is an important signal to us as these systematic strategies have traditionally done a fine job of sniffing out the new market leaders before the indices recover. We believe that the next market leaders will be different than the previous ones (AAPL, MSFT, TSLA, META, etc). We also believe this continues to be an environment for individual stock picking, and not investing in equity indices. While the major equity markets are in downtrends, there are multiple individual stocks in uptrends and making all-time highs. That is where equity exposure should be allocated to.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range. We see little reason to increase the allocation until our quantitative and qualitative metrics indicate a more constructive environment. Daily new highs vs. new lows, McClellan summation indices, EMA crossovers, and our proprietary Sundial models all indicate an adverse equity market environment. When equity markets eventually resume an uptrend, we expect there to have already been a marked increase in exposure in our tactical equity strategies along with an improvement in the above metrics. Until then, risk is better allocated elsewhere.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects our defensive stance. We continue to utilize mostly alternative yield generating investments and avoid Government and corporate bonds. Quality deal flow coming to us in commercial real estate has substantially increased. We will continue to be choosy as we do expect prices in general to continue to adjust lower, however, we get the sense that sellers are starting to come to reality, as their existing low interest rate loans against properties are coming due.
We are starting to see some interesting self-storage and industrial deals again. We are also seeing an increase in seller financing being offered in deals.
Our other preferred strategies such as litigation finance and reinsurance continue to have nice tailwinds and we view their risk/reward has far superior to traditional fixed income investments.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: 2022 ended up strong for classical trend following strategies, despite some give back of gains in the 4th quarter. The macro picture is murky in our view, and we aren’t proponents of trying to predict markets anyway. We do believe is that the environment continues to be constructive for trend following strategies. Additionally, many of these strategies can be accessed through mutual funds and ETFs opposed to private fund investments, so there really is no excuse for investors having zero exposure. We continue to believe these “dislocation seeking” strategies will be a critical component of asset allocation over the next few quarters.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: These investments have done a whole lot of nothing for the past year, which isn’t surprising as there really hasn’t been an “extreme tail event” this year. The grind lower in equities along with an absence of a significant spike in implied volatility was the pain scenario for these strategies in 2022. That being said, these strategies really didn’t lose that much considering how weak the opportunity set has been. As mentioned above, the cost of tail protection (skew) is quite low, the potential for a left fat tail is increasing, and we are strong proponents of this exposure in all portfolios.
CHARTS & TABLES:
Yet another reminder how important it is to minimize large drawdowns. This chart is a throwback from a post by Taylor Pearson in October 2021.
A lesson on the impact of fat tails and black swans: If you missed the 20 best days of the S&P from 2000 to present, your annualized return went from 8.33% to -0.52%. However, if you missed the 20 worst days, your annualized return went from 8.33% to 18.82%.
Source: Taylor Pearson @TaylorPearsonMe
S&P 500 earnings are nearly 20% above their long-term trend.
Source; Mike Zaccardi, CFA, CMT @MikeZaccardi
https://twitter.com/MikeZaccardi/status/1604941925144223744
A Quantitative View of the relative amount of volatility in equity markets:
Source: Álvaro Oviedo ���� @alvoviedo
https://twitter.com/alvoviedo/status/1604965175148261376
Monetary policy is far tighter than the effective fed funds rate. The divergence between the proxy rate used by the FRB and Fed funds rate is the biggest ever.
Source: Jonathan Harrier, CMT @jonathanharrier
https://twitter.com/jonathanharrier/status/1604937359442575361
A nice visual of the Fed’s balance sheet and the magnitude and pace of rate hikes.
Source: https://twitter.com/CiovaccoCapital/status/1608823457462251526
Fed Chair Powell’s Speech at the Brookings Institution at the end of November had some interesting graphs. Here are a few of them. If nothing else, it shows that Powell is aware that the real estate related impacts to CPI operate with a lag.
Source: https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm
Source: https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm
Some interesting data on rents:
Source: Seth Golden @SethCL
https://twitter.com/SethCL/status/1609949150229008385
Source: Callum Thomas @Callum_Thomas
https://twitter.com/Callum_Thomas/status/1609508192853299206
Source: https://twitter.com/i/lists/1473638010927394821
Disclaimers
This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities nor does it constitute tax advice. This information is for informational purposes only and is confidential and may not be reproduced or transferred without the written consent of Sundial. Past performance is not indicative of future results. Statements and opinions in this publication are based on sources of information believed to be accurate and reliable, but we make no representations or guarantees as to the accuracy or completeness thereof. These materials are subject to a more complete description and do not contain all of the information necessary to make any investment decision, including, but not limited to, the risks, fees, and investment strategies of an investment.
This correspondence may include forward-looking statements. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties, and contingencies. Forward-looking statements are not a promise or guarantee of future events.
Benchmarks and indices are presented herein for illustrative and comparative purposes only. Such benchmarks and indices are not available for direct investment, may be unmanaged, assume reinvestment of income, do not reflect the impact of any trading commissions and costs, management or performance fees, and have limitations when used for comparison or other purposes because they, among other things, may have different strategies, volatility, credit, or other material characteristics (such as limitations on the number and types of securities or instruments) than the Firm. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. We make no representations that any benchmark or index is an appropriate measure for comparison. The S&P 500® Index is a stock market index from S&P Dow Jones Indices. It is a market capitalization weighted index of 500 of the largest U.S. companies, designed to measure broad U.S. equity performance.
Asset allocation and diversification will not necessarily improve an investor’s returns and cannot eliminate the risk of investment losses. There are no assurances that an investor’s return will match or exceed any specific benchmark.
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