As I was collecting my thoughts to write this, I heard someone talk about reasons to be fearful of the market on CNBC, and the 1979 song "Reasons to Be Cheerful-Part 3" by Ian Drury popped into my head. Thanks to YouTube, I listened to it - it IS a cheerful song - and it is not a terrible backdrop for this investment commentary.
While we have talked about the underlying themes that we think are important for longer-term valuation and risk, investors in equity markets seem to be more focused on near term technical factors. This is one reason that we have seen such significant market volatility since February as the bull and bear camps fight it out during the trading day. One of the distinct themes that has been put to the test recently has been the "buy the dip" mentality that has worked very well for the past two years but has suffered recently as equities have pulled back 10% from their 2018 high. The rise of computer driven algorithmic trading strategies have exacerbated this phenomenon. It is estimated that 60%-70% of all trading is now done through algorithmic based models. This becomes especially important because while the mathematics behind each algorithm strategy are unique, there are fundamental factors and certain common performance metrics that drive the success of most programs regardless of their complexity. In layman's terms - the programs tend to think alike under certain scenarios. One of the by-products of this is that short-term price swings can become exacerbated when there are no offsetting trades. We have seen this price action recently with several late afternoon moves that have dropped the S&P by 1% - 2% in the last hour. Throw in weekend Trump Twitter rants about Amazon, trade tariff concerns, and a general feeling that the "party has gone on too long" and you have the ingredients for the market environment we have today. Since we talked fundamentals in our last note, we will now cover some of the more short-term "technical" concerns we are seeing today.
Amazon and the Tech Market
President Trump's recent Twitter barrage of the company and its relationship to US Postal Service profitability is not that surprising, given his dislike for Amazon founder Jeff Bezos and the Washington Post (which is owned by Bezos). What is surprising is the continued market reaction in the price of AMZN. Trump has recently focused on taxes and the profitability of the USPS in his latest Twitterstorm. Some of the sell rationale can be attributed to fears that tech companies will suffer more regulation as a result, although this is counter to most of the Trump deregulation agenda and is based more in fear than reality. Amazon is clearly not the reason that the USPS is losing money - the biggest impediment to profitability is their embedded cost structure, which includes pension liabilities and healthcare. Most people who are knowledgeable about the situation say that the deal is actually a net benefit to the USPS because they bear none of the processing costs. Regarding the tax issue, if you have ordered from Amazon in the last five years, you have probably noticed that they are collecting taxes from your state. So, while this might have been an issue in 2012, it is not very relevant today. If this scenario had emerged last year it might have been a one day downward move and quick recovery, but in 2018 this may play out longer (remember Trump's Boeing rant about Air Force One? - the stock is up 100% since then). As we have seen time and time again with Trump and Twitter, he usually comes out swinging hard and then softens his stance. This does not seem to be an issue that will take down tech long-term.
Are FAANG Stocks De-fanged?
One of the hallmarks of a correction is that the best stocks are usually the last to react. This is exactly what we are seeing now, as Facebook, Amazon, Apple, Netflix, and Google have all suffered losses greater than the market averages over the past two weeks. Given the lower risk tolerance evident today, we are in a "shoot first, ask questions later" environment. This is not great news for traders looking at the short-term, but it also signals that the "correction" may be close to running its course. While prices may continue to be volatile over the short-term, we think that this will play itself out over the coming weeks.
Amazon's biggest regulatory risk stems from a potential Department of Defense contract for cloud computing that it is in position to win. They are the clear leader in the field, but White House pressure (along with other tech companies in the space) may cause this contract to be re-allocated. With respect to Google and Facebook, the recent Federal Trade Commission nominee Joseph Simons is considered to be a regulatory "hawk" so there may be some headwinds ahead. Again, with all of the drama surrounding NFLX and AMZN, would it surprise you to know that the YTD returns are 45% and 18% respectively?
As we look to see what near-term catalysts are ahead, the Put-Call Ratio comes to mind. This indicator, which measures the total number of traded put options divided by call options, is used to gauge the overall sentiment of the market. When the number is high, it shows that investors are trying to protect against further declines by buying more puts than calls. Interestingly, when the indicator reaches extreme levels it is usually a reliable contrary indicator. Currently, the ratio is in the 99th percentile. While this tends to be an early signal, markets tend to rally from these levels. During the February sell-off this indicator was in the 85% range, so it was not considered a complete washout. There may be some more volatility, but we would not want to be short the market with levels this extreme.
All in all, this is a tough market for traders who are focused on every short-term market swing. It's a good thing that this does not describe our investment process. The reality is that short-term market movements in a volatile environment are not necessarily indicative of longer-term trends. Our focus on risk rather than return has served our clients well so far this year, as our TAAP Portfolios have outpaced the S&P500.
* The TAAP Portfolio strategy materially differs from the composition of the benchmark used for comparison.