The Fed Takes Center Stage - Postcards from the Florida Republic - December 11, 2022
Current Outlook: I’m convinced that people are wasting too much time speculating on the timing of rate cuts and Fed pivots. Either you fully invest for an economic recovery in the back half of 2024, or you’re willing to be an active trader that tracks momentum. Speculation around rates and recession in an algo-driven market is a fool’s errand… and narratively tiring.
Serious Question: Did someone think I wouldn’t pay additional Disney World fees to cut lines, gain an extra 30 minutes in the park daily, or pick the exact time I’d like to ride?
Current Mood: Anxious about exposure to large crowds of other peoples’ children.
Dear Future Florida Republic Residents,
On Sunday, my family and I drove to Orlando. Home of Disney World.
This is allegedly the Happiest Place on Earth. I’ll be the judge of that.
Over the next two days, I’ll enjoy my favorite two pastimes.
1) Watching my daughter explore new worlds with a smile ear-to-ear.
2) Having people dressed in ridiculous work costumes separate me from my disposable income.
I had many articles to write ahead of four days off (I promised my wife I wouldn’t work on a vacation for the first time… since we met.) I don’t have enough time to cover all the bases of the market. So, this week, you get what you get. And you don’t get upset.
Momentum Is Negative… Don’t Crash Forever, Mister Market
This week, the markets prepare for a wealth of economic data. The Consumer Price Index (CPI) arrives on Tuesday morning. The Federal Reserve will likely raise interest rates by 50 basis points on Wednesday. (There is still a small bet on 75 basis points right now).
The markets have priced in that 50-point move. Merrill Lynch said that it expects the Fed to go 50 points higher – and projected another 50 issues for February (and 25 in March). Goldman Sachs now predicts a similar pace.
But – take a big step back. This week’s question isn’t whether we go up by 50 basis points or 75 basis points.
The question is how much higher interest rates ULTIMATELY go. Merrill and Goldman now project a move toward 5.0% to 5.25%.
Fed Chair Jerome Powell has signaled mainly that the Fed will go higher for longer, even if the central bank does so with smaller hikes at a time. The market only sees the Fed funds rate moving to roughly 4.6%. That’s a somewhat surprising disconnect now.
I’ll be screaming: “The Fed needs to go to 5.25%!” while riding down Splash Mountain.
That could be the story of this week. We already have six members of the Fed openly stating that the rate must go to 5% or higher – with James Bullard in St. Louis saying up to 7%.
Yet, the market doesn’t buy it. At some point – that reality must set in, right? That would only move the yield curve to an even greater inversion. It would also likely drive the U.S. dollar higher - which is a cheap yet effective bet for Friday on the Dollar Bullish Index (UUP).
Then, on Friday – meanwhile – we’ll see Quadruple Witching. Investors are trying to determine whether a Santa Claus rally will arrive after options expiration this week. The chart below shows the performance of the S&P 500 after December Triple Witching since 1990.
So, what do we see here?
In the previously ugly markets of 2002 and 2008, the needs pulled back after Quad Witching. And although 2018 delivered a positive return for the post-Quad Witching event, there was a dramatic selloff (and pivot from the Fed) that month.
The only logical approach is to ride the momentum.
We’re currently sitting in an adverse momentum event for the S&P 500 and the broader Russell 2000. This will be an exciting week, and I’m not sticking around.
If the Fed doesn’t really act – and show its commitment to higher rate hikes – it could quickly lose control of the financial markets. I’m talking about falling bond and mortgage rates, a rally in equity markets, and a weakening dollar. I don’t see that happening…
But know knows: If you need me, I’ll also be the guy rocking back and forth in the shower, mumbling, “It’s a small world after all. It’s a small world after….”
The Economic Situation Is NOT IMPROVING, PETER!
This guy Peter will text me on Monday. And when he reads that I’m increasingly bearish -especially after the momentum move last week – he’ll say, “what about X piece of data.”
To which I explain – the entire YIELD CURVE FROM SIX MONTHS TO 30 YEARS IS INVERTED!
The Energy Market is a Wreck
I stumbled upon a message from Bloomberg's prominent reporter and opinion writer.
Lisa Abramowicz said the following:
The answer makes sense when you look in the right place.
In the global oil markets - there are two participants.
Some producers (and the downstream operators) use the futures market to hedge their output, lock in a price, and raise capital on expected production. They have skin-in-the-game. So do independent refineries, chemical producers, and other companies that use the actual product.
Then - there are the speculators. These are the individuals who have no skin in the game. They never really handle any crude oil. They provide liquidity to the market by trading in the futures market. Yes, their speculation can pump prices much higher, but they are viewed as a necessary participant because capital is critical to a booming marketplace. We don’t want wide bid-ask spreads, especially in a futures market.
Hedge funds are among the essential speculators in the business. We look at the Commitment of Traders report each week to see how much funds are trading various commodities. This report - released by the Commodity Futures Trading Commissions (CFTC) - tracks the funds’ movement in metals, oil, natural gas, currencies, and much more.
We spend much time tracking Commodity Trading Advisors or CTAs. They are the funds that use managed futures strategies to turn a profit. Last week, funds slashed their exposure to oil ahead of the Russian oil price cap implemented by Western nations and the OPEC meeting. As a result, we see the lowest amount of exposure to oil by CTAs in about a decade.
Why does this matter? The simple explanation is that the participants with very little skin in the game exited the market in the year's final month. Every trader I’ve spoken to has packed up their knapsack and gone skiing for the rest of the year (or at least some other mindless recreational activity over which I’m jealous.)
This is now an algorithmic market with minimal buying. And that’s significant. Because the paper futures market is estimated to be anywhere from five to ten paper contracts for every single barrel of oil trading. We’ve seen all the oxygen sucked out of the market.
I anticipate that the oil markets will recover strongly in the second half of next year - and there remains a very tight supply challenge over the next four years. It would be best if you were patient. But it all starts with understanding where to start right away.
The Worst Stocks of 2023
This week, I did a little experiment. I reversed many of the data feeds I sought for relatively strong companies and instead focused on the worst crap in the market. Because I want to know who is going out of business…
It took 38 seconds to find the worst three public companies out there.
I started with a scan of negative price-to-earnings (P/E) to know they don’t make money.
I looked at a price-to-sales (P/S) ratio well into the double digits to question what any remaining investors think regarding the valuation on earth.
Then we targeted the balance sheet. Let’s find something terrible. Something with a Piotroski Score under three and a Z Score (bankruptcy risk) under 1.5.
That’s right. We want to make sure that when these firms go under in 2023 or 2024, there is an implosion that we can see from miles away. It has to be so bad that not even private equity would bother with these companies. So, let’s a recap.
- P/E Ratio: Negative
- P/S Ratio: Over 10 (Even 20)
- F Score: 3 or Less
- Z Score: 1.5 or Less
And that brings us to three stocks.
First, Richard Branson’s Virgin Galactic Holdings Inc. (NYSE: SPCE)
Sir Richard Branson was able to make a lot of money on his Virgin brand. And plenty of other executives sold SPCE stock over the last five years. Since 2017, executives have sold $1.6 billion in SPCE stock. They’ve only bought about $100 million in that time.
Virgin Galactic is in the business of space tourism. But the stock continues to crater from its all-time highs. In 2021, shares popped above $55 per share. Today shares trade for under $5.
There’s a reason for this... The company’s numbers are terrible! Virgin Galactic has an F score of 2, a negative Z score, and a P/S ratio of over 769 times.
To justify its price today, the company would need to provide 100% of its revenue to investors for the next seven and a half centuries. You’ll probably walk on the moon before you can justify owning this stock ever again.
Then we have Nikola Corp. (Nasdaq: NKLA)
Remember this so-called Tesla-killing electric vehicle company? It’s the worse. It might be a plague on investors. Anyone still holding this thing should get free government healthcare – because they also perceive both crappy ideas as a value.
Remember… Nikola’s Founder, Trevor Milton, was found guilty in October of fraud — he artificially pumped up his stock and engaged in wire fraud. He’ll be sentenced to up to 25 years in prison in January.
Nikola’s stock looks like a company heading toward delisting and bankruptcy. Its balance sheet is a mess, with an F score of 2 and a Z score of negative 2.77%. The price-to-sales ratio is now at 22.4x. Owning this stock is the equivalent of a grease fire.
That’s much math…
Finally, we have Odyssey Marine Exploration Inc. (Nasdaq: OMEX). So, hey, kids. Imagine that you could own a stock with the insane and improbable moonshot of Virgin Galactic combined with the financial instability of Nikola.
Great news: Odyssey Marine Exploration.
Because why go to space when you can explore the cold-dark lunar feel of the ocean’s bottom? And with this stock, your money is also likely heading to Davy Jones’ locker.
The company operates in deep-sea exploration, focusing on procuring minerals under the oceans. This company started in the exploration business of shipwrecks, but then it found an excellent narrative for a public market with no ability to control reckless speculation. Why wouldn’t they exploit the utter stupidity of YOLO investors in 2020-2021?
OMEX has an F score of 3 and a Z score of negative 35.7. Simply put, this company is a creditor away from a serious problem. Its P/S ratio is 40x, meaning I’d be in my 80s by the time this stock justified its current price.
The only reason that I can think of to invest in these companies is if you’re heading for divorce and you don’t want your ex-spouse to have the money. Aside from that… save your cash.
Ready for a Chart Party?
Fine day for a selloff… a finer day for a chart.
Chart No. 1 – The Contrarian Play of 2023?
The chart below summarizes CEO business confidence for the U.S. economy six months into the future. As you’ll see, confidence is even lower today than it was during the recession of 1991, 2002, 2009, and 2020.
Want to guess what happened within 12 months?
Source: Michel Arouet
Chart No. 2 – The Contractors are Lying to You
One of our broadcasters caught me on Thursday before the show to talk about a remodeling project in his house. He said… “When is the price of lumber going to come down?”
Come down? It’s been crashing for the last few months.
It turns out his contractor has been telling him the opposite. Which begs the question… how many other contractors are telling people that lumber prices are still elevated?
Lumber is now off 78% since May 2021. It’s bearish for the housing market. It’s bearish for remodeling contractors. This isn’t even good for woodpeckers or beavers.
Chart No. 3 – Pay That Man His Money
Here’s a subtle reminder that if you own a company and people stick with you… don’t be upset if they have a second job. Job switchers this year have earned a stunning 7.5% increase in pay, while people who have stayed are up about 5.5% year-over-year.
This is the largest gap in decades.
Chart No. 4 – Biden Keeps Pumping Out the Crude
For political reasons, the Biden Administration wasn’t pumping oil out of the Strategic Petroleum Reserve ahead of the election. The actual talking point of these people now is that they saved the global economy by selling America’s strategic emergency supply.
Uh-huh? I swear these people are shameless.
If that’s the case – why are they still dumping U.S. crude?
Last week, U.S. crude levels fell to their lowest point in 36 years. It was 65 straight weeks of oil sales, and we had the largest drop EVER this year.
Chart No. 5 – Will Money Rotate Out of King Apple?
It was a challenging year for many managers at exchange-traded funds – as valuation compression and Fed policy speculation pushed asset prices lower.
ETF managers have engaged in more crowded trades to align with their benchmarks. A fine example is a widespread adoption of Apple shares to ETF portfolios, both active and passive.
In January 2021, 289 ETFs owned AAPL shares, according to ETF.com. By December 2021, the figure had increased to 320. By the end of 2022, the tally grew to 403. The proliferation of ETFs is undoubtedly a driver of the trend. Still, the significant increase over the year also explains an ongoing adoption of various technology stocks to better align with the performance of benchmarks – largely the S&P 500 ETF (SPY) and the Invesco ETF (QQQ). Apple represents 6.52% of the weight on the SPY and 13.2% on the QQQ.
Such decisions may have violated the original investment thesis of the ETF itself.
For example, the Global X S&P 500 Catholic Values ETF (CATH) is a fund that aims “to provide an efficient solution for investors looking to invest by Catholic beliefs.” So, what does a 6.47% weight in Apple (AAPL), 5.44% stake in Microsoft (MSFT), 2.51% stake in Amazon.com (AMZN), and 1.73% stake in Alphabet (GOOGL) have to do with Catholic values?
The Fund’s NAV has a nearly identical performance if the S&P 500 500 Index fund and carries a 26.4% stake in information technology stocks. Again, someone needs to explain the investment thesis. At the same time, these funds may continue to hold a large swath of technology stocks, the threat of forced selling, capitulation, or capital rotation among funds to other assets.
Should thematic ETFs start to sell assets like AAPL and move back to their investment thesis – this could create interesting price action across the market.
Apple’s market capitalization now equals the bottom 180 companies in the S&P 500.
Will we finally see a great rotation out of this stock?
In-Depth: Value in 2023
While I was digging through the trough of bad stocks, I stumbled upon something neat.
I doubt you’ve heard much of a company called Friedman Industries Inc. (NYSE: FRD)
This is a tiny steel parts manufacturer based in Texas. Its market capitalization is just $64 million, placing it in the bottom barrel of the nanocap space. The company produces steel sheets for the shipping container industry. It also makes tubing for the ever-successful oil and gas industry in the Texas basins.
The stock is so tiny that most investors couldn’t find it on a database. And it’s simply too small for hedge funds or private equity companies to own. If a hedge fund is deploying $1 billion in cash, it must file at 10-F and take a board seat with just a $6-million investment. That won’t do.
This stock is so ignored and illiquid that it trades for about $0.60 on the dollar. Its tangible book value — a measurement of its assets on the balance sheet — puts the stock at $13.94.
But imagine that it went under and had to go to auction. Even at $0.75 on the dollar — remember, we’re talking about a steel parts company — the stock would be at least $10.45.
Today, it trades at $8.74. That’s a 16% discount from the auction scenario.
So — in that situation — I should buy the stock and hold it, right?
After all, I’d be getting one heck of a sale.
Well, that’s not been the case in 2022. Look at this chart.
This small-value stock is trading like a momentum stock.
Look at the selloffs. They align perfectly with the momentum dates that I listed above. They came in January, April, June, and August.
Now, look at the rebounds. Three times this stock has dropped to about $7 — or about half of its tangible book value. And three times it has rebounded back above $10.
So, if I bought at $7 three times and sold at $10 three times, I’d have more than doubled my money this year. How crazy is this to think about.
I’m adding FRD to my radar as it presents a special situation. In a market of chaotic momentum moves, it’s always wise to look down at the illiquid parts of the market.
If I’m going to buy this stock, I always set a limit order and never purchase at market price. I could quickly distort the buy/sell order flow and pay more than I should.
Postcards from the Florida Republic
This is one of those weekends where I’ll be forward-looking and less backward-looking…
Wish me luck…
Enjoy your week.
Garrett Baldwin
Editor, Postcards from the Florida Republic
I comment on Financial Markets CLICK #jcobservations to see my posts
1yEnjoy Disneyland, Garrett - Family is far more important than any old claptrap that we all spout out on social media in the guise of economic advice If you have a good week, sell the S+P and buy Disney shares I'm with you on the higher, later terminal rate and the overdue sell-off on the S+P