Market Commentary:
Our views remain the same as has been expressed in the last few publications:
• We are in the midst of a great repricing of risk, that is partially driven by a significant transition from excess liquidity to the removal of excess liquidity.
• The correlations between stocks and bonds moved back to positive as we highlighted as a real risk back in the summer of 2021. History shows there are long periods where stocks and bonds do not hedge each other, particularly when inflation is elevated.
• Inflation isn’t transitory. It is secular in our opinion. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed.
• If inflation only declines to 4-5%, the market is not priced for what the Fed response may be (even higher rates and also remaining there for longer).
• 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.
• The price of money is a very significant driver of asset prices and economic activity. This has been the largest, fastest increase in rates ever. The impacts show up with a lag.
• The distribution of potential outcomes 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.
• 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 loss of purchasing power.
• Active management should generate far better risk reward than passive investing. • Don’t under-estimate the potential for either a grind lower or a gap lower in equity indices. • The window of long volatility strategies to have some significantly positive performance is opening.
Many of you may remember the titration experiment in high school science class. The appearance that nothing is happening while drops are being added, and then a binary change in color with the addition of one additional drop. This concept often appears in markets and economies in our opinion and is particularly relevant right now. We believe that the impacts from the many rate hikes and quantitative tightening have not yet appeared, but when they do, they will be significant. “Risk happens slowly, and then all at once” is the market’s version of a titration description.
An Interesting Study:
We came across an interesting study from Tony Dwyer at Canaccord Genuity this month, and we generally agree. His study be summarized as follows.
• History indicates that the only way October was "the" low in the equity market is if there will be no recession in 2023. Otherwise, the low is yet to come.
• In all of the recessions since 1957, the S&P 500 bottomed during or after the recession, and never before. • The extreme yield curve inversion and also the decline in LEIs indicate firmly that there will be a recession in 2023 (graphs below).
• Based on this, even if the Fed pivots, that may not be a buy signal for stocks
Two Questions:
We have received two questions with some regularity, so this is an opportunity to share our answers with a wider audience:
Question 1: Tactical equity strategies – aren’t they a bad idea? Multiple large investment advisors pound the table that investors must stay fully invested in equities all the time because of the drag on returns from missing the 10 best days.
Our Answer: What those “always remain fully invested believers” fail to mention is the even more massive outperformance if you are instead able to avoid the 10 worst days. The graph below is a powerful illustration. The tactical equity strategies we utilize attempt to avoid the large market drawdowns, even beyond the 10 worst days. So why aren’t tactical equity strategies a core component of the large firm equity allocation? We believe it is because large firms are not set up to be able to avoid the “10 worst days” type of markets. They focus on constructing massively scalable portfolios utilizing generic investments that simply move with the overall equity indices and are not designed to minimize drawdowns in times of turmoil based on our conversations. That way they can manage portfolios for hundreds of billions of dollars and millions of clients. While that certainly is a better solution than not investing at all, it is not an acceptable solution for those who have amassed enough wealth to be able to access much more robust portfolios that can contain both passive and tactical equity strategies, in our opinion.
We like to think of it this way: When driving a car, on sunny days it is safe to drive at the speed limit on the highway. But what about on a dark night with heavy snowfall? Do you drive at 65 mph then? Of course not. So why do you believe that driving your equity allocation at 65 mph in all conditions is a good idea?
Our combination of a passive allocation and a tactical allocation to equities results in driving at 65 mph in good conditions as both strategies are fully invested and driving at 30 mph in treacherous conditions as the passive equity allocation is still fully invested, and the tactical allocation has most likely shifted to a heavy cash allocation.
2022 has thus far been a year of treacherous equity market conditions that warrant driving at 30 mph, and this passive + tactical framework has been a significant benefit for us.
Source: https://twitter.com/markminervini/status/1596958429771624448 & Goldman Sachs
Question 2: Why isn’t Private Equity an explicit allocation in our portfolios?
Our Answer: We believe that Private Equity is highly correlated to public equities, but with less liquidity and less transparency.
The following commentary posted by Eric Balchunas of Bloomberg this month reflects our thoughts:
Private Equity investors may not get the diversification benefit they desire as private equity increasingly moves in tandem with the public market. The correlation between the MSCI ACWI and Refinitive Private Equity Buyout indexes is around 96% - the highest in two decades based on our June analysis. Between the MSCI ACWI and Refinitive Private Equity Buyout indexes, the figure is 84%, just off the high of 88% over the past 20 years. Investment advisors have advocated PE as the ultimate diversifier for multiasset portfolios, expecting them to have low correlations to public equities, thereby reducing volatility and improving a portfolio Sharpe ratio. But data show that in times of stress, private and public equity are one and the same – except that the former isn’t liquid.
We aren’t against private equity as an investment at all. What we don’t subscribe to, is that PE is a diversifier. It is a short volatility, or stability seeking asset just like public equities are in our opinion. Believing PE is a nice diversifier to public equity is akin to drinking 2 mixed drinks and then switching to beer in order to sober up.
At this time, we much prefer earlier stage venture investing, on a limited basis where we are actively involved in the company, or we are familiar with those who are driving the value creation.
Podcast Recommendation:
For those who like podcasts, I suggest listening to the November 24th Masters-in-Business interview with Boaz Weinstein. The following comment from Boaz is not being thought about enough with many investors we speak to: “This is not the same market that we were in. We are in the equivalent of playing tennis in a thick fog where we can’t see the ball. Anyone who thinks they can clearly see the future direction of rates or risk assets is not someone to listen to with confidence.”
https://www.bloomberg.com/news/audio/2022-11-24/boaz-weinstein-on-investors-unknown-risk-podcast
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 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: These systematic strategies generally disengaged from the equity market at the very beginning of 2022. What is interesting to note is that they have started to re-engage in idiosyncratic opportunities on a selective basis. While the level of investedness is still far below 50%, this is an important signal to us as the tactical equity strategies have traditionally done a fine job of sniffing out new market leaders.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range, and they have been there since the fall of 2021. We see little reason to increase the allocation until our quantitative and qualitative metrics indicate a more constructive environment.
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. We are starting to see some interesting self-storage and industrial deals in the southeast again (not in Florida). From what we are hearing, new development has slowed in many CRE assets (exception is multi-family housing), as availability of the amount and price of debt capital is uncertain. We are also seeing an increase in seller financing being offered in deals.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: This asset class continues to be a strong performer in 2022, as there have been some huge trends, such as a stronger dollar, higher government bond yields, lower equity indices and higher commodity prices. These strategies have pulled back a bit in terms of performance this month, and we are using the modest drawdown as an opportunity to add to positions. 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 in 2022, 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 has been the pain scenario for these strategies. As we do believe the great repricing of risk is not over, and there are multiple potential tail events to come in 2023 (China – Taiwan; More aggressive than expected Fed; More persistent than anticipated inflation) we are committed to the full allocation.
We encourage readers to reach out to us if they would like to discuss in more detail the instruments and funds that Sundial utilizes within each of these categories.
We will end this month’s commentary with the final paragraph of the Interview of Sam Zell in David Rubenstein’s latest book, “How to Invest” as it is a very important final thought.
“Good investors focus on risk. Risk is the downside. Those who focus on containment ultimately have a greater percentage of succeeding.”
CHARTS & TABLES:
Topic: Recessions and Equity Market Bottoms:
This is a table of US recessions since 1957, and is referenced in the Interesting Study section above. The table shows that every time, the low in the S&P500 was “in or after” the recession, and not before it.
Source: Canaccord Genuity – Tony Dwyer. https://vimeo.com/775918203/513ede8571
This chart is also related to the Interesting Study section above. The current extreme reading on yield curve inversion implies that a recession is highly likely based on historicals.
Source: Canaccord Genuity – Tony Dwyer.
https://vimeo.com/775918203/513ede8571
Topic: Equity vs Bond Implied Volatility:
Graph of MOVE vs. VIX Indices. It may be difficult for equities to stage a significant, stable rally until bond volatility subsides. Implied volatility in the bond market remains stubbornly elevated (red line).
Source: Trading View
Graph of Risk Reversal Indicator:
This measures the relative implied volatility of 30 days to expiration, 25 delta put – 25 delta call. During times wherein traders expect high risk, put values are bid up, which results in the RR indicator having values less than 0.10. The market is currently up near -0.05 which coincides with readings of low fear (a.k.a. flat skew).
Source: SpotGamma. https://spotgamma.com/founders-note-for-2022-11-29-0641-am-est/
Topic: Growth, Inflation & Equity Markets
We continue to be concerned about the potential for medium term structural inflation. The market is not priced for this in our opinion. The following growth and inflation pictures from Bridgewater paint an interesting picture. Higher inflation readings for longer than anticipated is not constructive for equity or bond markets in our opinion, and we also don’t believe this possibility is currently priced into markets.
Source: Michael Kao @UrbanKaoboy
https://twitter.com/UrbanKaoboy/status/1593413297025429504?s=20&t=B0XRUrNmPFdGcsQkpRzlFQ
Source: Michael Kao @UrbanKaoboy
https://twitter.com/UrbanKaoboy/status/1593413297025429504?s=20&t=B0XRUrNmPFdGcsQkpRzlFQ
Source: Michael Kao @UrbanKaoboy
https://twitter.com/UrbanKaoboy/status/1593413297025429504?s=20&t=B0XRUrNmPFdGcsQkpRzlFQ
Also, according to commentary published by Bridgewater, past equity market bottoms have achieved these 4 macroeconomic and value conditions. Food for thought for the die-hard equity bulls:
Source: Seth Golden @SethCL
https://twitter.com/SethCL/status/1593588822490681345?t=kE98qE8ZhyP7qlg2Pcd35g&s=09
Topic: Options Markets
Extremely short-dated options have become a popular trading instrument. These options have significant gamma and can cause large market swings.
Source: @zerohedge
https://twitter.com/zerohedge/status/1593430787223072768
Topic: Consumer Finance
Credit card balances are increasing and the interest rates on those balances are also increasing.
Source: Danielle Dimartino Booth
https://twitter.com/DiMartinoBooth/status/1594769463962136576?t=OWJdJLDN8LDtdr_COyHASg&s=09
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.
.png)