I hope all is well with you and your family and that you are all healthy and safe.
In this newsletter I will review the Actualize Fund’s performance, recent market activity and analyze whether we are in for a phenomenal rally or a painful crash.
Fund Performance
The Actualize Fund provided a net return of 1.37% in January compared to -0.54% for the HFRX Equity Hedge Index and -1.01% for the S&P 500. Since inception in May 2019, the fund has returned 97.8%. Our fund’s historical return correlation with the S&P 500 is 15.8%. See the attached tear sheet for more details.
Market Recap
As predicted in the January newsletter, we experienced a nice January Effect rally through January 26th followed by a brief breather on Jan 27-29th. Since then, the rally continued bringing us to all-time highs on multiple broad market indices, for example on Monday the S&P 500 closed at an all-time-high level of 3,915.59.
We have identified six narratives that are driving the market’s ongoing rally:
- Enormous fiscal stimulus – Biden’s $1.9 trillion stimulus is on a fast track to be approved and will translate into stronger demand for goods and services. This will likely be followed by an equally massive $2 trillion-dollar infrastructure plan.
- The economy looks ripe for a rapid expansion, in fact Goldman Sachs boosted its US GDP forecast to 6.8% in 2021 up from 5.9% at the end of December.
- S&P 500 Q4 earnings are surprisingly good with 82%of the companies reporting results that beat consensus EPS estimates, which is above the five-year average of 74%. In addition, companies are beating EPS estimates by an average of 13.6%, which more than double the five-year average of 6.3%.
- The Federal Reserve has pledged to keep interest rates near zero for months or even years as long as it falls short of its two major goals, which are to foster maximum employment and price stability.
- Continuing decline in the numbers of new Covid-19 cases. Over the past week, there has been an average of 108,144 cases per day, a decrease of 35 percent from the average two weeks earlier, allowing a quicker reopening of the economy.
- Vaccine availability is accelerating with at least 100 million Americans vaccinated by the end of March and vaccines widely available by April, sooner than previously expected.
With these six compelling narratives, the stage is set for a faster reopening, higher corporate earnings, low interest rates combined with a massive Federal stimulus – this is a bull market’s dream scenario and should lead to a once-in-a-lifetime rally, right?
What could possibly go wrong?
Irrational Exuberance
For those of you who remember the dot com bubble, the current market environment is starting to look strangely familiar. I keep getting a sense of Déjà Vu.
Remember when companies used to be able to IPO just by adding a .com after their name and use eyeballs as an accounting metric…well it feels remarkably familiar. Today all you need to do is either:
- Launch a SPAC, like everyone is doing
- Invest according to Reddit’s Wall Street Bets, ala Gamestop
- Follow the clean-energy mania by investing an EV company
- Invest in a joke cryptocurrency or any cryptocurrency for that matter
Clearly market euphoria is already here and we all know how this story ends.
However, rational investors wonder: are we in 1998 or 1999?
It is remarkably hard to know how long a bubble will last, it could be weeks, months or even years before a significant market correction…unless you have a warning system, which luckily, we do.
AI Model Warnings
Our proprietary Artificial Intelligence system is called B.A.I.L.A. which stands for Bayesian AI Learning Algorithm. It is designed to use Bayesian Learning to detect patterns in asset pricing and predict bull or bear phases of the stock market.
Over the past 2 weeks, BAILA has identified economic patterns which indicate that the market has advanced too quickly and a pull-back is imminent. It has flashed correction warnings predicting that the market will drop by 5% or more over the next 4 weeks!
This is the first time in about 2 years that BAILA has raised a significant warning flag, so I am taking it seriously. Does this mean markets will fall? Not necessarily, but there is a better than even chance that it will over the next few weeks.
Valuations Worries
The cyclically adjusted price-to-earnings (CAPE) ratio, developed by Noble Laureate Robert Shiller, is currently at 34.77, exceeding its level prior to the start of the COVID-19 pandemic. There are only two other periods when the CAPE ratio in the US was above 30: the late 1920s and the early 2000s. In both cases, the following 10-year return was abysmal.
As mentioned in our December Newsletter, on November 30th Shiller published a tool for handling the gap between the CAPE and interest rates which he calls the “Excess Cape Yield,” or ECY, a simple spread: it expresses CAPE as an earnings yield, rather than a multiple, simply invert the CAPE ratio to get a yield and then subtract the ten-year real interest rate.
The ECY in the US is currently 3.7%, which is derived from a CAPE yield of 2.9% (1/34.77) and then subtracting a ten-year real interest rate of -0.8% (10-Year Treasury yield of 1.2% minus the preceding ten years’ average inflation rate of 2%). That means we can expect a real return of 3.7% over the next 10 years – which is low, but better than Treasuries, right?
Hmmm, well the 30-Year Treasury just hit 2% on Monday and expected inflation is moving up steadily with the 10-year rate at 2.22%.
I expect that long-term rates will continue to rise to keep up with inflation and it is only a matter of time before the calculus of the attractiveness of equities vs. bonds will start shifting back towards bonds. And when that happens hold onto your seats.
In Conclusion
The next 4 weeks should be bumpy and based on BAILA’s predictions, I expect a 5-10% market correction.
In preparation for the potential market turbulence ahead, the Actualize Fund is taking our metaphorical foot of the gas pedal. We are taking a more conservative market posture, reducing our net market exposure, and holding specific short duration (high yield) stocks that should do well in a rising interest rate environment.
If you’d like to learn more, I’d be happy to continue the conversation.
Please be safe and healthy!