KDM Capital 4Q Market Letter

 

“Embrace the Suck: To consciously accept or appreciate something extremely unpleasant but unavoidable. It's necessary to achieve your goals. Over the long term it’s the only way to add value and it exists precisely because many others can't tolerate it."

 -Military Saying

 The S&P 500 was down 4.38% in 2018. The first down year since 2008. It was also the worst December since 1931! According to Bespoke Investment Group, 34% stocks in the S&P were down well over 20%. 50.5% were down 10%+. Indeed, the market internals was quite grim, especially given where we were at the end of Q3. However, I believe fear is a useful and necessary aspect of investing. There are two types of fear when it comes to the markets. Fear of missing out, and fear of losing too much money. For most of the year, investors were afraid of missing out. Stocks are much easier to buy when they go up. The higher they go, the cheaper they look.  Moreover, when they are going down, it’s hard to 'put money to work.' That was indeed the case in the last quarter of 2018. Going into 2019 the market is cheaper than it was in the middle of 2018. The forward multiple on the S&P is around 14.5x, a double-digit discount to its multiple over the last 20 years. In comparison, Ten year Treasury Bonds have a 'multiple' of about 39x, which is expensive compared to equities. Market participants are adjusting to dynamics that have rarely if ever been seen. For instance, technology deflation seems to be affecting the relationship between the Federal Reserve and Inflation. Whether its Amazon in retail, fracking in energy or fintech in financial services, new technology is putting downward pressure on prices, perhaps keeping inflation in check. Plus international government debt pays next to nothing to own, pushing more capital into US Treasuries which also puts downward pressure on rates. All this seems to be creating a quandary for the Fed.

 

Going into 2019, I have a few thoughts. First, stocks are cheaper and more attractively priced than just a few months ago. Second, the Fed has backed off ‘auto-pilot’ and 'will be patient and flexible with monetary policy.’ Perhaps no rate increases in 2019? Or even a rate cut? Possibly a moratorium on their balance sheet runoff? In any case, a more dovish Fed should be good for equities. Next, China has also stated it is undertaking measures to boost its markets like providing ample liquidity by issuing govt bonds, less stringent lending, and stopping ‘Forced Technology Transfer,’ a huge sticking point in the trade negotiations.

 

The world’s two biggest economies simultaneously undertaking more dovish monetary policy should be a tailwind for risk assets, which have become inexpensive by historical standards. It’s always easier to buy stocks when they are going up. The higher they go, the cheaper they look. Conversely it’s always easy to sell a bottom. However, as most experienced investors have learned, Selling into a downdraft has never been the right thing to do. As much as the market is predicated on data, i.e., earnings, cash flows, book values, and so forth, it's also one giant complex neural network which adaptively incorporates the collective expectations of investors into stock prices.

There are times when securities are a reflection of investor angst and not of company fundamentals. Those are the periods to be bought, not sold. I believe you own great franchises. Many are generating high levels of free cash flow, have low debt, growing their top and bottom lines and are genuinely disruptive. My goal is to invest in companies with a long tail. In due time, I believe investors will regret not adding more capital to these investments.

 

Regards,

 Andre McClure

KDM Capital

1 Little West 12th St. New York, NY 10014. Investment Advisory Services offered through KDM Capital LLC. Securities offered through Saxony Securities, Inc. Member FINRA/SIPC

Behavioral Alpha 2018

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"Mindfulness," "Being Reflective, not Reflexive," "Calming thoughts to avoid 'hot' situations." No, this was not a yoga retreat, this was Behavioral Alpha, 2.0. Behavioral Alpha is an annual event hosted by Essentia Analytics. Being mindful and reflective was an overriding theme of the conference. However, it's purely alpha driven. Investors who attend this event are genuinely looking for an edge in an extremely competitive investment landscape.

 More and more, investors realize that understanding their heuristics is crucial to minimizing investment mistakes and enhancing chances of success. Behavioral Alpha discusses how your data points can be used to foster better decision making which invariably leads to better outcomes, i.e., alpha.

 One major highlight of the conference was the revelation of never before seen research, conducted by Chris Woodcock, Snezana Pejic and Isabel de Nadai, on how portfolio managers and traders behave after being on winning or losing streaks, defined as any five-day sequence in which the fund was either positive or negative on each of those days. Does behavior change when on a streak?  Did managers make 'better' decisions when on a winning streak? Alternatively, do managers make 'worse' decisions when losing? The findings of the study are fascinating and illustrative to how understanding behavior patterns can help produce better results. Recognizing how a change in behavior affects decision making and the outcome of those decisions is truly pioneering work. After all, performance is an output. Behavioral Alpha offers a way to better understand the behavioral inputs of the decision-making process.

 Another highlight of the one-day conference was the guest speakers.Maria Konnikova, the author of 'Mastermind' and the 'Confidence Game,' discussed how our instincts could lead to bad decision making when dealing with outsized personalities. The psychology of avoiding 'the con' is not dissimilar to avoiding bad investments because of a 'slick pitch.'

 Anastasia Buyalskaya presented her research on how companies incorporating changes such as adding cognitive diversity and streamlining the decision-making process can help create better outcomes.

 The conference ended with a poker tournament that allowed the attendees to use some of their new found skills at the poker table. After all, poker is about sizing up the competition, calculating the odds of having a winning hand and deciding if the other players are bluffing or are likely to have a better chance at winning than you. Any player of the game knows all these calculations take place in a matter of seconds with incomplete information. Much like investing and trading.

 As the world becomes increasingly data-driven, we must be able to examine our patterns and find the 'signal in the noise.' Essentia provides high powered analytics to assist a manager in detecting the signal and translating that into real alpha by giving a positive feedback loop.

Essentia offers tools that thoughtful professionals can use to add real value to their clients. They act as a guidepost nudging us to slow down, reflect on our past behaviors and use that mindfulness to make better investment decisions going forward.

 

I'm already looking forward to what Behavioral Alpha 3.0 will bring!

 

Andre McClure

KDM Capital LLC

 

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High(er) Times!

As earnings season is underway, it’s quite obvious that Q1 reports are very strong. In fact S&P earnings are up about 18% over this time last year.  Typically, when earnings increase, market multiples expand. Interestingly,  the forward multiple on the S&P has contracted by about 11%, from a forward PE of roughly 18.2x to 16.56x*. Earnings have increased while the markets have gotten cheaper.  Stocks have also experienced a huge increase in volatility over last year.  So far in 2018 we’ve seen 34 days of 1% moves*. We had 8 such moves in all of 2017! So where does the S&P 500 stand after all that fire and fury? Down 0.71% ytd!* I’m sure Sisyphus would be sympathetic.

One oft cited reason for the increased volatility is rising interest rates. Indeed, higher rates do act as friction on free cash flows, earnings, etc. as business’s have to refinance their debt at higher rates. Higher input costs and weak pricing power have also added to corporate angst.

These higher costs are seen as offsetting the benefits of the corporate tax cuts enacted last year. Higher rates also makes ‘risk free’ investments more competitive to equities. The “multiple” on the 10 year Treasury note has decreased from 44x this time last year to about 33x currently.

Rising rates have also taken a toll on investor sentiment. Bullish sentiment has dropped from 36% in January to 32.7% in April. If you go back a little further, to November, sentiment was over 50%!*

With that being said, I see falling sentiment as positive for higher stock prices. I also believe rates and equity prices can move higher together. In fact, this time last year the 10 year Treasury yield was 2.30%. Its currently about 3.03%*. That’s more than a 30% increase in treasury yields.

The S&P has appreciated by roughly 10% in the same time period. To quote David Tepper, “Wake me up when the 10 year hits 4%”.

In the meantime, I believe the market is adjusting to  higher rates by attempting price discovery in assets that benefited from historically cheap financing.

I think the volatility is a reflection of that process.

In my opinion equities continue to be long duration assets for investors with a multi-year investment horizon.

Andre

 

*-Y Charts

*-CNBC

*-Standard & Poor’s

*-Bespoke Group

*-Market Q

After The Streak ...

February marked the first down month for the S&P 500 since March 2017 (ten straight months of gains).  However, on a total return basis, the streak of gains was very impressive at 15 straight months heading into February. There have only been five other periods where the index saw a double-digit streak of gains. The longest was 15 months, which ended in May, 1959!

Interestingly, in the month after the first down month, the S&P 500 was up every time for an average gain of 4.65%. In fact, in addition to being up every time in the month after the first down month, the S&P was up over the following six and twelve months as well. Three months later, the market was up four out of five times and the one down period was a decline of less than 2%.

There is one caveat. The weakest recovery following a double digit streak of gains came after the 15 month run that ended in 1959. However, historically investors resumed their buying after these long streaks of gains came to an end.

Source: Bespoke Group

Source: Bespoke Group

Strong Starts...

The S&P is off to its best start of the year since 1987. Through the close on 1/23/18, it’s up 6.12%. That ranks as the seventh-best start to a year dating back to 1928. It’s the best start since 1987, when the index was up 11.53% through 1/23. There have been nine other years where the market traded up 5% or more by 1/23.

There are wide ranging outcomes, but the average return for the whole year was 10.85%. The median return was 20.09%. However, five of the years saw drawdowns from the peak of 17.10%, 13.42%, 24.34%, 27.10% and 52.98%! The other four saw drawdowns of less than 1%.

Two of the nine years finished down, while the other seven were up. The two down years were during the depression.

Year                  YTD 1/23                              Rest of Year                        Entire Year

1987                     11.53                                      -8.52                                 2.03

1934                     10.83                                    -14.03                                -4.71

1976                     10.00                                       8.32                                19.15

1938                       8.44                                     14.86                                24.55

1967                       7.54                                     11.67                                20.09

1931                       7.04                                    -50.55                              -47.07

2018                       6.12

1985                       6.02                                     19.17                                26.33

1975                       5.12                                     25.14                                31.55

1980                       5.10                                     19.68                                25.77

 

Year End in Review

Happy New Year! 2017 saw the S&P end up 21.83%. In light of such a strong showing, I’ve been asked if I believe the rally can continue. In short, my answer is yes. But perhaps not quite as much as 2017. From an economic perspective, indicators like Auto Sales, Housing Starts and the ratio of Leading to Coincident Indicators are all at or near cycle highs. Historically, even when they peak, recessions tend to be about a year off. Valuations are running high, but stocks are seeing re-ratings as a result of tax reform. Even still, higher valuations usually aren’t a catalyst for a market move. So unless there is a catalyst, valuations are not a good timing indicator.

From a market perspective, the internals seem solid as well. For instance, market breadth remains positive. Every S&P 500 Industry Group is trading above its 200 day moving average. In the ten other periods when this occurred since 1990, the S&P was higher three, six, and twelve months later every time. Also, when markets finish up over 20%, the subsequent year tends to deliver double digit gains. We’ve all heard the saying “Bull markets don’t die of old age and they don’t die because of valuations”.  Usually their demise is the result of an economic downturn or some exogenous shock. The former doesn’t seem to be in the cards and no one can predict the later. With that being said, the market seems to be in a position to have another good year.

A few notes on 2017:

  1. Energy and Telecom were the only two sectors down;
  2. Large stocks outperformed small stocks (The 50 largest stocks gained 19.42% vs. the 50 smallest  which gained 7.21%)
  3. Growth outperformed Value
  4. 2017 was the 9th straight up year, which ties the streak from the 1990’s (91-99).
  5. Low dividend stocks outperformed high dividend stocks
  6. Stocks with heavy international exposure did better than domestically oriented names; Stocks with heavy international exposure were up an average of 33.84%
  7. Near record low volatility with only 8 one-day moves of +/- 1% (The last time that happened was in the mid 60’s!)
  8. 409 calendar days without a 3% pullback
  9. 539 days without a 5% pullback
  10. 676 days without a 10% pullback (second longest stretch on record)

*Data provided by Bespoke Group