More than 23 years ago, the Information Technology sector peaked relative to the S&P 500 index. From its dotcom bubble highs in 2000 to its lows in the fall of 2002, Tech dropped 80% and lost two-thirds of its value relative to the rest of the market. Two decades later, we’re finally setting new all-time highs.
It wasn’t easy, especially over the last 3 years. Those former highs acted as stiff resistance on every rally attempt. First it was the 2000 monthly highs, then the weekly highs, then the monthly highs again. Each time it looked like things might be turning the corner, sellers stepped in and pushed Tech back lower. But a failed breakdown in the first weeks of this year was the catalyst needed to finally find fresh air.
The bigger the base, the higher in space. And 23 years seems like a pretty big base to us. We think Tech is structurally positioned to be a leader for the months and years to come.
True, AI-fueled speculative frenzy in May might have pushed things a bit far in the near-term, but Tech isn’t ‘stretched’. It’s gone nowhere for two decades! This ratio has another 18% to the 138.2% Fibonacci retracement from the dotcom collapse. We’ve got 30% to the 161.8% retracement. Those are our intermediate term targets for the sector. (Remember, since we’re talking about a ratio, those are gains relative to the S&P 500, not on an absolute basis.)
Those are lofty targets, and we don’ think we’ll go there in a straight line. Though we’re quite bullish on the sector longer-term, we believe rotation is the life-blood of bull markets, and we’re poised for some flows back into some un-loved spaces of the market.
The equally-weighted tech sector relative to the equally-weighted S&P 500 index just found resistance at its former highs. This would be a pretty logical place to see tech overall start to pull back.
Of course, that won’t happen if the mega caps keep dominating the way that they did in May. That could happen, and to some extent we’ll need the mega caps to keep leading if we expect tech to keep outperforming longer-term. But we doubt the same playbook is going to work all the time. A broadening of the rally would be healthy.
“Don’t try to time the market. Stocks average 10% returns over the long-term. Just keep buying. Stick to the plan over the long-term, and everything will work out.”
We hear it all the time from financial advisors and investment gurus these days, and not for nefarious reasons: Humans are dumb. Too often, we allow emotions to control investment decisions, and our many behavioral flaws cause us to make sub-optimal decisions. That’s a big reason why so few investors are able to beat, or even match, the returns of benchmark indexes over time – our brains seem programmed to sell at the bottom and buy at the top.
One of a financial advisor’s most important jobs is to help their clients overcome those psychological short-comings. And the easiest way to do that is to entirely remove decision-making from the process. Thus, passive investing has become a dominant force in the industry.
Unfortunately, it’s been fueled in part by a bunch of narratives and statistics that mask the reality of historical returns.
It’s true that large caps stocks have averaged 10% gains over the last 100 years or so. But the odds that any of us will match that 10% annual gain are probably a lot lower than you think – even over extended timeframes. A single number simply isn’t sufficient to describe what’s actually happened.
Consider a 10-year investment horizon. Starting with the late-1920s, large cap stocks have gained as much as 21% per year…. or dropped as much as 4.9% per year. For a $5,000 initial investment, that’s the difference between $34,000 and $3,000!
Hold on, you say. Ten years isn’t that long. If you started investing at a young age, you’ve still got plenty of time! You’re right. So what about 20 years?
The good news is you’ve at least managed to achieve a positive return no matter what start date you were gifted. The bad news is returns are still wildly unpredictable – just 20% of the data fall within 1% of the central tendency. The maximum endpoint of that initial $5,000 is now a whopping $143,000, but the unlucky investor ended up with just $7,300. Good luck making a financial plan with that!
Luckily, if everyone managed to ride out the turbulence of their first 20 years and make it to 30 years, the distribution of returns tightens considerably. Even investors born at the worst time managed an annual gain of nearly 8%. Still, a 7% gap between the best and worst periods, compounded over 30 years, becomes a vast difference in experienced returns: $300,000 vs. $50,000.
The problem is, we’re still ignoring a few realities. For one, returns are nominal, but we tend to think in inflation adjusted terms. The median salary in the United States is about $70,000 today. If wages track the Fed’s annual 2% inflation target, that same median salary will be closer to $130,000 in 30 years. Our future buying power and retirement nest eggs need to be similarly adjusted. That’s harder than it sounds. It’s difficult to conceptualize how living expenses will change and adjust our financial plans accordingly, and it’s just as hard to guess the future path of inflation (especially after the last few years). It’s much easier to simply look at historical returns on an inflation-adjusted basis
Additionally, we aren’t actually investing like in the examples above. Nobody invests their entire nest egg and then waits for 30 years – we’re making contributions over time. And the mechanics of dollar cost averaging widen the dispersion of historical returns.
The effects of inflation and periodic contributions to an investment portfolio can push internal rates of return below 0% even when investing for 20 years! Let’s say you invested $100 each month for those 20 years, for a total of $24,000 in contributions. That strategy would have yielded a retirement portfolio as large as $130,000 in today’s dollars, based on historical returns. Or you could have ended up with just $20,000 – less than the value of your contributions.
Over a 30-year horizon, the ‘average’ return is still quite useless. You might end up with $45,000 or $250,000.
And what if we take it all the way out to 4 decades? Might we finally see some consistency? Unfortunately, no. ‘The plan’ said you’d end up with a quarter of a million in today’s dollars by investing $100 a month for 40 years. You might get that. You could also end up with double that amount. Or half. Because average returns aren’t that useful.
Even these scenarios are oversimplified, because people don’t invest the same amount each month or each year. Most of us are able to invest more the older we get. And that will lead to an even wider distribution of outcomes. It’s the big moves that come near the end of the investment horizon that have the largest positive or negative impact on actual outcomes.
I’m not here to bash passive investing. It’s still the best approach for a lot of people – especially the ones that would otherwise succumb to the worst of their behavioral flaws. Remember, plenty of investors underperformed even those negative outcomes above. But let’s not pretend that investing is a one stop shop, where the same strategy can work in any environment. It just isn’t that easy.
And stop treating ‘average returns’ as gospel. They don’t come close to adequately describing history.
Whether we like it or not, we’re all playing a game of market timing. You can blindly hope that you were born at the right time, or you can take the future in your own hands. Only you know which path is the right one.
As for me, I’ll keep my focus on looking for profitable trends and managing risk. Even if I can’t match the best of index returns, perhaps I can limit the swings and have a higher degree of certainty about my financial future.
This week’s Means to a Trend post is running a bit behind schedule. Apparently, so is market breadth.
I last talked about the weak breadth in this market a month ago in a post titled, Breadth isn’t bad. It just isn’t good. And that’s okay. At that time, I noted that it takes TIME to repair structurally broken trends. Last year, stocks experienced their worst bear market since the bottom in 2009 – decline that took 18 months to run its course. It took another 4 years before the S&P 500 reached new all-time highs.
With that context, it’s a bit unfair to expect a broad, healthy uptrend in stocks to begin overnight. Still, with both the SPX and the NASDAQ closing at their highest levels of the year, it’s disappointing that breadth hasn’t shown improvement. In fact, in many ways it’s gotten even worse over the last month.
There’s a base metal which is said to have a PhD in economics. Right now, it needs a different kind of doctor.
Copper just ended the week below its 200-day moving average for the first time all year after dropping 3.7%. Over the last 4 weeks, it’s fallen more than 9%, the largest such decline since the metal bottomed last July. The recent weakness comes despite the long-awaited and ongoing economic reopening of China, the world’s most important copper consumer.
Copper is quite sick indeed.
Partly to blame for last week’s bloodbath is the US Dollar.
The Dollar Index roared 25% higher in just 18 months following its May 2021 low, as interest rates moved up and the US economy offered a safe haven from the turmoil in Europe and the lockdowns in China. After finally peaking last fall, the Dollar quickly fell back to the top end of its 2016-2021 range, providing a tailwind to equity and commodity prices along the way.
Now, the index is trying to rally from this long-term level. Back-to-back half-point gains on Thursday and Friday drove the Dollar to its best week since peaking last September.
Copper isn’t the only base metal under pressure. Zinc, nickel, and aluminum, are all trending lower, too.
Crude oil has suffered a similar fate, despite a surprise production cut from OPEC in April. OPEC production cuts have an inconsistent track record when it comes to propping up oil prices. This time, the announcement served to push crude higher for a few weeks, but now we’re back to where we started. Their cut was in response to the risk of weakening global demand and macroeconomic uncertainty. If that pessimistic outlook proves correct, though, no amount of collusion will be able to offset the decline in consumption. Lower oil prices over the past few weeks reflect that risk.
I’ve got something a little different this week. My oldest daughter had her first ever t-ball game on Friday, so I decided to sit down and finish a post that I’ve wanted to write for a long time.
For those of you who didn’t know me a decade ago, I was lucky enough to play baseball at the collegiate level for four years. I managed to win a few games here and there, but my name doesn’t grace the record books. Reaching the next level wasn’t in the cards, either. No, my career had zero lasting impact on baseball. But the sport had a lasting impact on me.
Baseball is the root of my connection with each my closest friends. I even met my wife in the dugout (and then promptly told her to leave me alone because we were in the middle of a game. I vultured my first collegiate win in relief just a few minutes later. True story.)
Just as important as the relationships made are the lessons I learned on the field. Here are ten that apply to investing.
1. Learn how to fail
Baseball is a weird sport. You can succeed just 30% of the time as a hitter and still reach the Hall of Fame. It’s a game where failure is the norm, and failure takes a mental toll. The greats learn how to compartmentalize those failures and move on. They make the next play. They focus on the next pitch.
The worst thing you can do is compound your error: You bobble a groundball, then make an errant throw because you’re in a rush. You give up an RBI double, then fail to back up third because you’re busy hanging your head. You strike out in a key moment, then pout in the corner of the dugout instead of cheering on the next man up.
You’re going to fail a lot in this world, too. Not every decision will be a profitable one. Your investment thesis won’t always pan out. But you can’t let the disappointment of past failures affect future decisions. Good investors don’t panic when a trade goes against them. They don’t change their thesis to justify holding on to losers. They aren’t controlled by the fear of missing out.
Keep a cool head and stick to your process.
2. Focus on the approach, not the outcomes
Good baseball players have good at-bats. Batting averages and slugging percentages measure outcomes, and outcomes are what win games. But outcomes depend on luck. The only thing you can control each and every time are your approach and your process.
You can work a pitcher deep into the count and then scorch a line drive straight toward a fielder. You’re out, despite a good at-bat. You can fall behind on a first pitch fastball down the middle, chase a curveball in the dirt, then manage to sneak a dribbler through the five-hole after getting fooled on an 0-2 change-up. You got a hit, despite a poor at bat. Over enough time, though, good at-bats are sure to result in hits more often than poor ones.
It’s the same thing for investors. You can make a ton of money on a hot stock tip that you got from your buddy in a bar. You can buy something you don’t understand, double-down after a drop because ‘surely it can’t go any lower’, and then get bailed out by an unexpected acquisition. The outcomes are good. The approach isn’t. For the vast majority of us, luck is not a sustainable investment strategy. We’ll have more consistently good outcomes when we take a good approach and stick to our process.
3. Trends persist
I remember reading Buzz Bissinger’s Three Nights in August right after it came out in 2005. The book is about a pivotal 3-game series between the St. Louis Cardinals and the Chicago Cubs, mostly viewed through the eyes of legendary manager Tony La Russa. (Full disclosure: I grew up in central Missouri, so I’m a bit biased.) La Russa was a matchups junkie, and he firmly believed in the persistence of trends in baseball. It doesn’t matter whether a mismatch is because of a physical advantage or a psychological one, if a hitter is 0-10 against a particular pitcher, he isn’t ‘due for a hit’. He’s due for another strikeout.
Trends persist in the market, too. A stock can drop 80%, but that doesn’t mean it can’t fall further. In fact, it’s more likely to keep falling than suddenly reverse course.
4. Do the work and be prepared for anything
Tony La Russa would prepare for each game by filling a 5×7 notecard with matchup statistics. No matter which opposing pitcher was brought in in relief, or which pinch-hitter was brought to the plate, he knew which of his own players were best-suited to handle the situation.
When you’re in the field, you’re constantly evaluating what to do if a ball comes your way, or where you’re supposed to go on a double to the gap. It changes depending on how many runners are on the bases, how many outs there are, how fast the batter runs, and what the score is.
The catcher is trying to outsmart the hitter based on which pitches he’s already seen and which ones he tends to hit best. The hitter is trying to outsmart the catcher based on what that pitcher likes to throw in certain counts and situations.
Baseball is a slow game to watch, but don’t be fooled into thinking nothing is happening. There’s a constant flow of ‘if-then’ analysis between the ears. When players or coaches aren’t doing that, they’re bound to be caught off guard and look the fool.
To quote the great Yogi Berra, “Baseball is 90% mental. The other half is physical.”
We have to prepare for markets in the same way. No one knows what will happen next, so we have to do our best to prepare for every possible scenario. If x happens, how will I respond? What if it doesn’t happen? What if x AND y happen?
When we’ve put in the work and prepared correctly, all that’s left to do is execute.
5. Life is easier when you’re ahead in the count
If you want to be a successful pitcher at any level in baseball, you must throw first pitch strikes. Getting ahead in the count gives you optionality. You can more confidently throw off-speed pitches, knowing a missed location can only even the count. You can nibble at the corners of the plate, rather than being forced to groove a hittable strike. You can give the hitter something to chase, knowing they really don’t want to fall further behind.
When you get ahead in the count, you significantly increase your odds of winning the matchup. Here’s some stats from the MLB last season:
Hitters that fell behind in the count on the first pitch of the at-bat had a batting average that was 40 points lower than hitters that got ahead.
For hitters that fell behind 0-2, the disadvantage is even more extreme. They hit just .160, while batters that were ahead 2-0 in the count hit .266.
The data says your success-rate depends on who wins the first pitch.
In investing, getting ahead early is just as important. We know that investment returns are skewed by the fat tails of the distribution curve. We also know that the best performing stocks tend to be among the most volatile. We need to own those volatile fat tails, but it’s hard to hold onto something for the long-term if the trade moves against you at the start.
It doesn’t matter what your investment horizon is. If you fail to time your entries appropriately, you’re putting yourself at a mathematical and psychological disadvantage.
6. Never throw a pitch you don’t want to throw
As a pitcher, you control the game. Nothing happens until you decide to throw the ball. You get to decide what you throw and where you throw it. Yes, your catcher is probably smarter than you, and he’s the one calling the game. But that’s no excuse for doing something you don’t agree with.
To be successful, you have to have confidence in what you’re doing on the rubber. If you’re busy complaining about what you think you should be doing, you’re not focused on what you are doing. You miss spots. Your movement isn’t sharp. You give up bombs. Then you blame it on your catcher because you didn’t want to throw that pitch. It’s not your catcher’s fault. It’s yours. Own your pitch.
Own your trades, too. There are plenty of ‘catchers’ out there to help you on your way – I try to be one here at Grindstone by pointing out trends, levels, and opportunities in the market – but only you can be held responsible for your investment decisions. It’s your money. You could be handed a highly profitable strategy, but if you don’t own it and believe in the system, you’ll find a reason to give up on it. You aren’t focused on executing. You’re focused on what you could be doing instead. That’s not a recipe for success.
7. Take what you’re given
I was a straight pull hitter. My specialty at the plate consisted of barreling up anything on the inner half and hitting hard groundballs to the shortstop any time a pitch was on the outer third. That’s why I was relegated to the bump in college (that and because my older brother was gifted all the foot speed in our family tree). The great hitters don’t try to do too much with every pitch. They take what they’re given. They’re capable of turning and burning on a fastball when the opportunity arises, but they’re willing to sit back and slap singles to right field when they have to.
We don’t get to invest in the market we want. We get to invest in the market we have. Good traders take what they’re given. If their preferred strategy doesn’t work when markets are rangebound, they’ll employ a new strategy in those environments. If they can’t make money in stocks, they’ll find a way to make money in commodities. If commodities aren’t working, they’ll look at crypto, or fixed income, or currencies. And if all else fails, they’ll sit on the sidelines, rather than try to force something that isn’t there.
8. Know how to respond when the odds are stacked against you
When you fall behind in the count, it’s not a great time to be swinging for the fences. Last year in the Show, there were more than 5,000 home runs hit. Only 3% of them came on 0-2 counts. Statistically, there’s no worse time for batters who are looking to go yard.
That’s not to say you can’t be a good 2-strike hitter. You just need to be willing to adjust your approach. Successful hitters get defensive and find a way to get the bat on the ball. They shorten their stride, choke up on the bat, simplify their swing. Trying to get out front and lift a ball in the air when the pitcher has the advantage is a good way to strike out a lot. Good things happen when you put the ball in play.
Similarly, you won’t hit a lot of home runs when the odds are stacked against you in the market. Bottom fishing and trying to catch falling knives is a good way to go broke, especially if you’re betting big. Is it possible that Mr. Market accidentally leaves a ball up in the zone, allowing you to clear the bases? Absolutely. But that’s not the higher probability outcome.
If you’re on a losing streak and you feel confused by the market action, is that the time to be doubling down and trying to recoup losses? Any great trader will tell you it’s better to get defensive and decrease position sizes until the advantage is back in your favor. There’s nothing wrong with a single every now and then.
9. Play to your strengths, not someone else’s
I wasted a lot of my playing career pretending I was something I wasn’t. I played shortstop in high school because that’s where my superstar brother played. My slow feet and long arm action made me ill-suited for the position. When I turned my focus to pitching, I wanted to be Nolan Ryan and blow fastballs by people, even though my velocity was little better than average.
It wasn’t until the second half of my college career that I found real success, and it was because I began playing to my strengths: the ability to throw a plus curveball in any count and to any part of the plate, and the ability to keep my very average fastball on the black. I was a lot better at being myself than trying to imitate someone else.
I’ve found the same is true in this industry. You don’t have to be a subject matter expert on every single thing. It’s a nearly impossible task, and it’s not a prerequisite for success. There are dozens, if not hundreds, of ways to make money in the market. You can be a pure technician, a bottom-up analyst, a quant-driven algo trader, or a macroeconomic asset allocator. The ‘best’ strategy is the one that works for you. If you try to invest the exact same way that Warren Buffett does, you won’t have the same success that he does. You have different strengths. Focus on what you do well, then be the best at it.
10. Fighting the people in charge is a waste of time
Everybody loves to hate umpires. There’s an entire ecosystem out there dedicated toward pointing out bad calls, complaining about rule interpretations, and asking for Angel Hernandez to retire. It builds a lot of camaraderie among fans – no matter which team they root for, they’re united in their hatred of officials.
Players and managers, too, love yelling at the umps. Sometimes, they’re justified in their anger. Other times, the game’s participants don’t even understand the rules they’re arguing about. In all cases, the outcome is the same: the call stands and the umpire goes back to doing his job.
Complaining about umpires is fun. But it’s a waste of time.
Complaining about the Fed, the SEC, or the President is a waste of time, too. Does screaming about rate hikes or the debt ceiling build camaraderie by uniting people against a common enemy? Sure. Will your 20/20 hindsight analysis of every mistake policy officials make change what they’ve already done? Does your opinion about what Jerome Powell should do have any impact on what he will do? No and no.
It’s easy to judge from the peanut gallery, but just as most baseball players don’t know the intricacies of the rule book, most investors don’t fully grasp the puts and takes of policy decisions in a global economy.
Umpires and policy makers are humans. They will make mistakes. We can spend our time bashing the people in charge. Or we can focus on finding ways to profit from their decisions.
In the bear market of 2022, growth sectors led on the downside. The tech-laden NASDAQ dropped 33%, far more than the declines seen for value-oriented groups . Things are different now. Big tech is pacing gains in 2023.
2. Communication Services is Leading the Way
The Communication Services sector has rallied 23% through the first four months of 2023, thanks in large part to a 92% year-to-date gain for Meta Platforms. Communications ended last week at its highest level since last August.
There are 120 GICS sub industries in the S&P 500 index. Only a handful are outpacing the year-to-date gain of the homebuilders.
Given the constant flow of negative sentiment surrounding the housing market these days – the predictions of imminent collapse, the mid-2000s comparisons, the affordability complaints – one would expect to see an industry in disarray.
Instead, homebuilders are breaking out to new highs on an absolute and a relative basis.
The concerns about housing are seemingly well founded. Since the Federal Reserve embarked on its fight against inflation, the average 30-year mortgage rate has climbed from less than 3% to as high as 7%. On a home with a 30-year mortgage and a 20% downpayment, that rate change shifts the monthly payment higher by more than 60%.
Somehow, that actually understates the affordability problem.
In March 2021, when the average mortgage rate was near 2.7%, the median sales price for a home in the US was under $370,000. Now, that median home costs closer to $470,000. Wages have increased over that same period, it’s true, but not by enough to cover the difference. The average monthly housing payment as a percent of income has nearly doubled in less than 24 months. By that measure, homes are more expensive than they’ve been in over 30 years – when mortgage rates were above 10%.
Affordability constraints have served to cool the surge in home prices. According to a recent article in the Wall Street Journal, home values along the west coast have fallen as much as 10%. Unfortunately for prospective home buyers, the weakness isn’t widespread. In the eastern half of the US, prices are still rising at a healthy pace. The Case-Shiller National Home Price Index has slowed from the record pace of 2021, but it’s still 3.8% higher than year-ago levels. That’s not something you’d see if the housing market was collapsing.
How can home prices be so resilient in the face of cost-constrained demand? Perhaps it’s the severe lack of available homes.
Last week I shared the chart below on Twitter and noted how the number of 52 week highs has declined on each successive rally this year. Fewer and fewer stocks are leading the way higher. That’s not a great omen as US indexes continue to challenge key resistance levels that have been in place for 8 months.
Does that mean a return to the bear market lows is imminent? Should we be selling all the stocks we own? What does a deterioration in new highs really say about breadth, anyway?
It’s starting to look as though interest rates have peaked, thanks in large part to the failure of Silicon Valley Bank.
In the weeks prior the banking crisis, every piece of economic data pointed to stubbornly high inflation and a tight labor market. That was the story driving Treasury yields higher all throughout 2022, and the latest batch of data pushed 2 year Treasury yields to the highest level since 2007.
In the weeks after the failure, though, 2 year rates have given back those gains and more.
Yields have fallen across the curve. Ten year Treasurys are breaking down to their lowest levels since last September.
Based solely on what we’ve witnessed over the last year, that would be a bad thing for the Dollar and a good thing for stocks. All throughout 2022 and into this new year, we watched as higher rates and a stronger Dollar pushed equities lower (and vice versa). Look at how closely the three moved together.
Will those relationship hold forever, though? Of course not. In fact, they’ve already begun to weaken.
The correlations between equity prices, rates, and currencies have rebounded from multi-decade extremes to something that more closely resembles an average.
Why might that be? Blame bank failures again.
Throughout 2022, lower rates reflected softening price pressures and bolstered hopes that the Fed could softly land a hot economy. Fears of a deep recession are the focus today. Deposits are flowing out of banks across the country and into money-market funds, and that disintermediation will force banks to pull back on credit issuance. Credit crunches often lead to deep recessions – a scenario which could force the Fed to lower rates.
But recessions just aren’t great news for stock prices, whether rates are coming down or not.
Do you remember when big tech was the ONLY place to invest?
Let’s rewind to the days before half the world closed its doors. From the end of 2018 to the pre-pandemic peak, the S&P 500 Information Technology Sector rose 65%. The Communication Services Sector, which sported 20% weights to both Alphabet and Facebook, jumped 40%. The S&P 500 itself climbed 35%. Not a bad year for investors, right? So long as they had their money in the right place, that is.
Over that 13 month period, every other sector underperformed the index.
Every market historian knows that the bulk of historical index returns are generated by a handful of names (that’s why we focus so much on identifying relative strength). Rarely, though, has that phenomenon been so readily apparent as it was that year, when more than 80% of sectors lagged the index.
