Risk Off: Time to be Cautious 💸

It's been a minute so let's dive right in!

Financially, we’re at a precarious point in time.

Same goes for the social and political side with the incredible decline in competence and sanity we've seen at the Federal and State levels here in the United States.

While US markets and the US dollar are still the best boats in a crappy flotilla, the risk/reward ratio is dialing up considerably.

Overall market indices are rising seemingly unaffected by the ongoing geopolitical and inflationary risks which abound.

Despite the Administration's best efforts to convince Joe Public that this is a great economy (Bidenomics!) and inflation is no longer an issue, most people with two eyes that actually shop for their own groceries know that's a bald-faced lie.

Even the much vaunted super strong employment numbers are a product of manipulated government statistics. Nearly all of the 'jobs' have gone to new 'arrivals' (ie illegal immigrants) and the remaining are a combo of part-time gig work or replacement of jobs that were destroyed during the madness of our Covid response.

A large part of the workforce never came back after the Covid shutdowns and the government does an excellent job at distorting the unemployment rate by using statistical tricks like the labor force participation rate and the birth-death component (essentially a way to add fictional jobs based on the number of people they expect to die or be born in a given period).

When it comes to inflation, the short and dirty is it's still a major problem and it's somewhat embedded at this point with higher wages creating higher costs for companies who then go on to raise prices to keep their margins.

There's also the increasingly high shipping costs for goods as a result of our bumbling efforts in the Red Sea and elsewhere dealing with the Houthi rebels. When ships are forced to change their routes and go a much further distance around Cape Horn rather than through the Suez or Red Sea, things become much more expensive. Shipping costs for goods are up 60% in some cases and that will flow thru to the consumer on the tail end.

The Fed was hopeful that asset prices of all types would come down (stocks, housing, etc) allowing them to cut rates and make it easier for firms and consumers to refinance their growing debt loads.

That doesn’t appear to be happening anytime soon. Wall Street expected continuous cuts beginning in March with 1.25% in total cuts this year and that has now been pushed back to May with many firms believing perhaps June now.

My two cents has always been that there's close to zero chance the Fed will cut with the stock market at an all time high unless there is some exogenous event or blowup (like a Too Big to Fail bank imploding).

Neither of those have happened and inflation readings are still high. As I wrote earlier, even the year over year (y/oy) inflation numbers which are now at approx. 3% don't give a real view of how painful inflation is for the average consumer.

Sure, inflation is down from a 10% y/oy back in 2022, but that means prices are still going up 3% and that is after a 50% or so increase in the previous 2 years (if you want to use real numbers and not ‘official’ govt numbers).

So anyone who tells you prices are coming down is flat out lying to you (and even the 3% number is based on phony govt numbers). Education, health care, and tons of other prices are still moving up far beyond the 3% rate.

Until stock prices or housing corrects, the Fed is stuck between a rock and a hard place. Especially with all the fiscal stimulus from our monster deficits and the laughably named Inflation Reduction Act still pouring dollars into the economy.

Housing is another obstacle to rate cuts as the price of housing has not corrected nearly enough. Other than small regions that were previously super-hot coming off double digits, most housing prices have only corrected 5-10%. And that's after a 50% climb from pre-Covid levels.

The bottom line here is there is simply not enough housing inventory. At only approximately 1 million units on the market, that's a historical low. Post-Great Financial Crisis in 2009, homebuilders got wrecked and never replenished the supply needed to fill new household formation. Add in the higher mortgage rates and those who own a house at a sub 4% mortgage are hesitant to sell creating a lack of available homes and keeping prices sticky.

All this leads to our current market chessboard...and it doesn't look great to me. Previously I've written about market gains being concentrated in only a handful of high capitalization names like NVDA, MSFT, GOOG, AMZN, & META (the so-called Magnificent 7).

That's never been more true than today. In fact, it's gotten even worse with the market really moving towards a single stock - Nvidia (NVDA) and it's eye-boggling gains over the past 6 months (Nancy Pelosi wins again...).

The market has become the all-NVDA market, and it's become the only barometer for where we go from here. If NVDA is up, the market is up, when it's down the market is down, and it hasn’t been down often. A stomach-churning 34% of the entire market's gains over the past few months have come from this single stock. I can't recall another time in history when a single company has been so critical to the overall market.

Under the surface, breath (the ratio of advancing stocks to decliners) has been weak. Back out NVDA and we're basically flat to down for the year. The Russell 2000 (an index of small cap stocks) is basically flat for the year and down nearly 20% off it's most recent peak.

That’s setting off alarm bells and pushing me to take a cautious stance.

On a recent coaching call, I said S&P 5124 would be the spot that I would look to get short, a very rare stance for me these days. Shorting is a pro's game, and even most pro's can't do it well.

Needless to say, if a China-Taiwan conflict pops off or any number of possible other Gray Swans it would be curtains for NVDA and this overextended, overvalued market.

Even without an exogenous event like that, it's rare that a company like NVDA can do what it's doing for any extended period of time.

Right now it's priced to near perfection and there's always hiccups along the way, either self-inflicted or created by external forces. No company executes flawlessly for a decade and that's what NVDA is priced at for now here above $800.

And it's not just NVDA, but plenty of other large cap tech stocks have followed creating a very lopsided, overstretched market that seems to be immune to rising geopolitical tensions and the inability of the Fed to get a handle on inflation and bring interest rates down.

I'm not saying we are approaching a cliff-type moment, but the risk of a significant one-day down move is rising.

If we look back to the 1987 crash (no, I don't expect a 25% down day like in 1987 but a 5-10% down day is not out of the question), two of the all-time best performers during the crash and ensuing 3 decades were Stanley Druckenmiller and Paul Tudor Jones (also two of my personal favs).

When pressed after the 87' crash why he flipped from bullish to bearish, Druckenmiller offered the following.

The ugly truth is that all of those factors that Druckenmiller mentioned about the market pre-87 crash are worse today than in 1987. Markets have changed significantly since then, so that fact alone is not dispositive however the general outlook as I've shown in previous letters such as the Shiller PE and other metrics are all near major market top highs.

It doesn't mean there aren't  attractive individual stocks out there, but it does mean IMHO that major market indices like the S&P 500 and Nasdaq are not great intermediate term investments at these levels.

In fact, I believe we will likely make a top for the year somewhere in the 5100-5200 range and will likely be short above 5125 as I noted above.

Adding to my bearishness is the avalanche of selling by smart people we've seen in the past few weeks. Here's a small sample of some of the more notable sales over just the last week:

• The Walton family sold $4.5B of Walmart stock.

• Jeff Bezos sold $9B of AMZN.

• Jamie Dimon (sold $150M of JP Morgan (his first sale ever of the stock)

• Mark Zuckerberg sold $650M of META (Facebook).

• Warren Buffett's cash position at Berkshire Hathaway is the largest it’s ever been.

• Goldman Sachs' data shows hedge funds are selling tech stocks post-NVDA earnings at the highest pace they've seen in over a year.

Again, nothing above is an absolute, but it is a another loud signal that I’d rather be a seller than a buyer at these market levels.

While I talk specific investments and actionable items for my Pro Subscribers, I will offer something that might be an interesting play here to keep track of and briefly explain the reasoning behind it as an educational lesson on why most leveraged ETFs are garbage investments.

SOXL: The Direxion Daily Semiconductor Bull 3X Shares ETF (ticker: SOXL) is designed to provide investors with leveraged exposure to the semiconductor sector, aiming for daily investment results, before fees and expenses, of 300% of the performance of the PHLX Semiconductor Sector Index.

In other words, the SOXL is a way to make a 3X leveraged bet on the semiconductor sector (that includes NVDA). If you buy the SOXX (iShares Semiconductor ETF) and the semiconductor index is up 10% in a month, the SOXL should be up 3X that, or 30%. So it's a way to magnify your exposure to the long or short side of the index. 

However, the nature of leveraged ETFs like SOXL introduces the concept of "decay," which can significantly impact the fund's performance, especially over longer holding periods.

Decay refers to the tendency of leveraged ETFs to lose value over time, particularly in volatile markets. This decay stems from the daily rebalancing of the fund's leverage to maintain its target exposure level. Due to this rebalancing, the effects of compounding returns can lead to performance divergence from the underlying index over periods longer than one day.

For example, if the underlying index of a 3x leveraged ETF like SOXL goes up by 1% one day and then down by 1% the next day, the ETF's value will decrease more than the index due to the amplified daily fluctuations. Over time, this effect can lead to significant underperformance relative to the index it aims to track, especially in volatile markets.

So if the SOXX was flat over the course of a 3 months, you'd expect the SOXL to be flat as well. However, due to the 'decay' mentioned above, the SOXL would likely be down several percent even in a flat market.

The play here with the SOXL is to short it expecting NVDA and other semiconductors to consolidate their gains and cool off (or correct).  If NVDA is down 5% you'd expect the SOXL to be down 15%. With decay, it might be even be down 20% or more.

However as I mentioned above, shorting is difficult for multiple reasons including the potential for unlimited losses. If you're long a stock, the most you can lose is the amount you invested if it goes to zero.

But if you're unhedged short, you are responsible for any and all future gains the stock makes. For example, if you sorted 1000 shares of Tesla at $100 (costs you $100K) and it goes to $1000, you're not just losing your original investment of $100,000, you're on the hook for a cool million ($1000 Tesla times 1000 shares).

The way to mitigate this risk is to buy put options in something you believe is going to go down.

Puts allow you to limit your bearish bet to the amount you invest.  If the stock goes up 10X in your face, you only lose your initial investment in the option (known as the premium).

Puts also allow you to make more than 100% on a trade. With a normal short, the most you can make is 100% (if the stock goes to zero). A put will keep going up as the stock goes down allowing you to make more than just a double (100%) on your bet.

In light of the above, an alternative to shorting SOXL would be buying SOXL end of March puts.

However, because the volatility is fairly high here (volatility is essentially a measure of how far the stock or index is expected to move), the puts are a bit more expensive. In options trading, the higher the volatility and the farther out the time, the more expensive the premium is (ie, June puts are more expensive than March puts).

I'll look to short the SOXL if NVDA makes another move towards my exhaustion target of $840 or buy some short term SOXL puts on a 'blowoff top' type move back towards the $840 level.

I'd think twice about piggybacking me here because this is a high risk trade but it's an excellent lesson to follow along and pay attention to as you can see how leveraged ETFs work and alternative ways to bet on a market going down (or hedge) besides shorting.

Here are some other Risks and Considerations around Leveraged ETFS

1. Volatility and Compounding: Leveraged ETFs are particularly sensitive to market volatility. The compounding of daily returns means that in volatile markets, the decay effect can erode the value of the ETF more rapidly.

2. High Expense Ratios: Leveraged ETFs typically have higher expense ratios than non-leveraged ETFs. These fees can further reduce the fund's returns over time.

3. Not Suitable for Long-Term Holding: Due to the decay effect and the high cost of maintaining leverage, SOXL and similar leveraged ETFs are generally not suitable for long-term investment strategies. They are designed for short-term trading based on daily market movements.

4. Potential for Significant Losses: In extreme market conditions, if the underlying index declines by more than 33% in a single day, a 3x leveraged ETF could lose all of its value.

Bottom Line: It's a great time to take some chips off the table. Markets are expensive, and completely ignoring the geopolitical, deficit and inflation risks that are out there. Make some sales and raise cash.

Or if you like sticking your finger in the socket, come short the SOXL with me on the next big NVDA up move. ⚡️

-Mike

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