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LeveFields Weekly Newsletter Jan 1 2023

It's been a roller coaster ride punctuated by events

LevelFields

Happy New Year!

Living through 2022 certainly met the definition of living in interesting times - perhaps too interesting. It's been a roller coaster ride punctuated by events: revenge travel, war in Ukraine, oil hits $130 per barrel, an energy crisis in Europe, tech stocks lose favor, an RSV outbreak, a monkeypox outbreak, a baby formula shortage, heatwaves, droughts, Roe v. Wade overturned, COVID worry ends in the U.S. and begins anew in China, hurricanes, burning Teslas, Elon buys Twitter and loses a fortune, Eli Lily claims it can kill obesity with a pill, Republicans win control of the House, META drops -65%, Crypto meltdown, FTX scandal, protests in China over lockdowns, a new British PM, global population hits 8 billion, quiet quitting, boomeranging, inflation hits highest rate in 40 years, central banks tighten, the Chips Act, technology export embargoes to China, housing market freezes, shipping prices drop -75%, coal makes a comeback, personal savings get obliterated, markets crash across the world, and a new global arms race which now includes space begins. It's been a year.

Now what?

The S&P 500 ended the year down -20%. The NASDAQ 100 ended the year -34% and the DJIA ended the year -9.4%. Where we go from here depends largely on the central banks, Russia, and how the Chinese handle the largest COVID outbreak ever.

The bulls are betting the U.S. Federal Reserve will become reasonable and begin cutting rates late in 2023 as the nation falls into recession. The bears believe the Fed will once again be slow to react to the economic data which shows inflation has already come down to 2.4% on a forward looking basis. If the trend stays, additional Fed tightening will fly us into deflationary territory and a recession.  

Our take is they are both right: The Fed will be slower to act than they could be due to fears of repeating the lessons of the 1970s when the Fed cut interest rates too soon, which resulted in the economy reflating again quickly. Eventually, the data will show inflation long gone and the Fed will cut rates quickly to stimulate the economy.

The bear/bull fight will play out in Q1 this year over the next Fed rate hike planned. Increases and no change in Fed tone towards a willingness to pivot to rate cuts will shift sentiment to the bear case and there will likely be a selloff giving way to a new market low for this bear market we're in. If we're fortunate, that will be the bottom, though the S&P 500 historically bottoms 3 months after a recession starts.

This is where it gets tricky. Technically, there was already a recession. A recession is defined as two quarters of GDP declines in a row, which happened in Q1 and Q2 2022 in the U.S.

Using the historical averages, the market would have bottomed already on Sept 30th. The graph does show this to be the bottom so far.

Q3 2022 printed GDP gains of 3.2%.  With high interest rates leading to lower economic output, it's likely we'll see another set of weak GDP numbers for the next two quarters though forecasts range from declines of -1.5% to small gains for all quarters. If we end up with negative GDP in the U.S. for the next two quarters, we're in a recession (again). The next market bottom could be the same as hit back in September or it could be a bit lower.

What can we do?

For the past 9 months, we've recommended staying in cash and trading events until the bottoming process is finished. Stay the course.

Taking advantage of short term trends by shorting the market with the SH or SQQQ has proven lucrative. Leveraging scenarios to see what companies are doing well and which are cutting staff in an attempt to become cash flow positive are good ways to generate outsized returns.

The layoffs will continue. The Fed's chart of employment growth (above) is pretty depressing. But we are entering an environment where the consumer has less to spend and is spending less and where companies are conserving capital and spending less. The layoffs are are inevitable consequence of shrinking demand and increasing supply - the cure for inflation.

Below, we give some ideas for leveraging layoff events for trading.

KNOWLEDGE CORNER: LAYOFF IT

Companies that have yet to turn a profit will continue to scramble as the rates for borrowing money increase, making borrowing expensive. As the interest expense rises and demand for new stock issuances decline, non-profitable companies will burn through cash levels faster, forcing them to cut staff. As the rate of revenue growth declines, such companies can find themselves in a free fall where they are burning through cash too fast. When unprofitable companies cut staff, it can be viewed as just the beginning of a downslide and the stock usually sells off.

Conversely, larger companies with more predictable or stable revenues and profits can trim staff to keep earnings growth stable or up. Not only does this cut costs, it's also a great excuse for companies to cut poor performers they were handing onto due to fears of not being able to find replacements. As the labor market softens, it becomes easier to hire people, alleviating such fears.

These companies are often rewarded for their shrewdness and for the potential for increases in productivity driven by the loss of perceived excess baggage by the market, driving share prices up.

TREND ANALYSIS: POST-RECESSIONS

Per that chart above, the average recessions causes a market decline of -29% for the S&P 500 index. This implies we have another -9% to go and would take the index down to 3494 - right where it was in October 2020. Keep in mind two things: 1) this is an average, and 2) ending down -29% doesn't mean the index won't shoot well below that number by 4% and come back up to finish higher the same day.  

That's the bad news. The good news is markets rise significantly after recessions. On average, the S&P was up +40% from the bottom over the following 12 months and +54% over the following 24 months.

Our current situation of high inflation and rising Fed fund rates has been compared most to the post WWII era and the 1970s. In both cases, the S&P 500 index came back strong in the 12 months following the market selloff - about +40% each time.

The pattern here warrants patient investing. We're getting close to a bottom, but there seems to be more to go before a longer term rally begins. We'll let you know when we think we're there and how to profit from it.  

For now, shorting the S&P 500 by buying 6-month put options seems reasonable, though it's always riskier to short and index than individual stocks.  

HIGHLIGHTS FROM LAST WEEK

Given the holidays and market closures, it was a pretty slow week for the market. But a few events are worth highlighting.

Goldman put a timetable on their layoffs

Goldman Sachs stated they expect their announced layoffs to begin this month. While the company has benefitted from increases in trading volume for commodities and fixed income products, they've taken a major financial hit from an abysmal IPO market and lower wealth management fees.

The Crocs Are Snapping...Back

The most beloved ugly shoes, CROX, has been on a tear. The stock started 2022 at $132 a day, hit a low of $48 in July, and has since risen to $108.43 with most of the gains over the past two months. It's still trading at a reasonable P/E of 12 and web traffic to the site has been increasing steadily as they improve their direct to consumer offering.

The stock was written off as a COVID purchase, lumped into the work-from-home in pajamas and Lulu lemon category. But the hedge funds got it wrong. Revenues continue to grow, showing the company is more resilient to trends.  

It recently broke out of its trading pattern and was flagged in our Quick Sprints scenario. Seasonally, CROX performs best during summer months and performs poorly in February, which may create an entry point in February.

MPLX Rises

Last week, we broke down a covered call strategy for MPLX. MPLX is yielding 9.5% in dividends and adding covered calls adds another 7%. The stock rose 2% last week.

Tesla Bottoms?

After a sentiment-led free fall that took the stock down to 107, Tesla shares rebounded to finish at 123. We mentioned selling puts on Tesla was one way to play the selloff in anticipation of the rebound for those looking to become longer term holders. Shares seem to have stabilized, and the opportunity to continue the strategy still remains as put premiums are still high.  

TLT Drops Below 100

The ETF which tracks the 20-year US Treasury dropped below 100 again, signaling expectations for rate hikes. The TLT runs inverse to the Fed Fund Rate.

Under 100, the TLT is a buy for those willing to hold it a couple years or more.  There may be some short term downside over the next few months, but it will ultimately rise as the Fed lays off rate hiking and investors seek shelter from volatile markets.

93 is the bottom for the TLT. If it hits 94, we'll buy long dated calls (2024+) and look for 100% returns.

GE Spins Off Healthcare Division

GE spin off its healthcare division as a new company, which will be included in the S&P 500. The stock (GEHC) will begin trading January 4th. GE is splitting up the company into 3 divisions: aviation, healthcare, and renewable energy.

The healthcare division sells diagnostic and imaging machines used by hospitals and doctors.

LevelFields_event_driven_winners_10Jun2022

Key Earnings Announcements This Week

January 4

  • UniFirst (UNF)
  • +11.57% (3 Months)
  • Personal Services
  • Uniform Rental  
  • The 5YR EPS growth rate for UniFirst is 2.29%.
  • Following a -8.27% (1YR) performance, but a recent upward price movement of +11.57% (3 Months), investors will look for an outlook on customer growth within the rental industry during a recession environment.

January 5

  • Bed Bath and Beyond (BBBY)
  • -83.61% (1YR)
  • Home Improvement Retail
  • With a weak yearly price performance amidst BBBY's recent retail rally earlier this fall, the home improvement company has been under pressure recently after disclosing that it had received a letter from the SEC regarding its 2021 fiscal report.
  • Helen of Troy (HELE)
  • -56.25% (1YR)
  • Household Products
  • HELE has been focusing on its global restructuring plan, aimed at expanding operating margins, and is expected to post earnings of $2.65 P/S- a -28.8% Y/Y change.  

Economic Reports Due:

  • Wednesday
  • FOMC Minutes
  • U.S Job Openings
  • Thursday
  • Jobless Claims
  • Trade Deficit
  • Friday
  • U.S Unemployment Report

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