VI Quant Fund - What is Your Battle Plan?

“He who fails to plan is planning to fail” -- Winston Churchill

With the markets largely volatile since the beginning of 2022, investors and asset managers have all turned their portfolios defensive amidst the rising interest rates.

Some investors short the market or hedge positions via selling put options on portfolio positions or buy ETFs inversely correlated to their portfolio. Others hold bonds, gold, or even cash to seek shelter from the volatility via other asset classes while others dollar cost average into a falling but high-conviction portfolio.

Whatever the plans, at least have one, and better yet, have it robustly back-tested. Investors who just “react” to market whipsaws will be in for a very rough ride emotionally and portfolio-wise.

Two key questions that we will need to answer to be able to draw up our "battle plans" are:
1. What is the sentiment on the stock I am holding/intend to buy?
2. What phrase is the market in right now? Still crashing, bottomed-out, or in recovery?

But I am a value investor, not a trader!

Like it or not, the narrative on the economy and the individual underlying asset drives market sentiments, which then drives price momentum, providing the tailwind for your portfolio returns.

We can buy and sit on an asset we think is undervalued for a very long time, but if the market does not see the value you see, your asset can remain undervalued for a very long time, resulting in opportunity cost had the capital been deployed elsewhere.

Take NYSE:BABA in 2021 as an example, solid fundamentals, healthy debt, good growth, and profitability and more importantly, deemed fairly undervalued since early-2021 and steeply undervalued since mid-2021 by many below $200. Yet for many that caught this falling knife and dollar-cost-averaged this stock found themselves still holding onto losses 1-2 years later as we approach the end of 2022.

Top image shows the price chart of BABA plotted against its 10 years mean P/S multiple (yellow) and +-1 std deviation on VI App.

Bottom image shows the price plot of BABA together with its 50 day & 200 day SMA on TradingView.

The simple solution for individual positions with a mid to long-term holding power? Viewing price charts alongside a mid-long-term moving average trendline (e,g, 200-day) and observing the gradient of the slope to help us better avoid catching the falling knife and fighting against mid-long-term negative sentiment momentum!

After doing fundamental due diligence on the company, an investor only needs to wait until the moving average trendline starts to change from a downward slope to flatten out before hitting that buy button to accumulate.

This means that from May 2021 till even now, at its deeply discounted state, is not the time to take a position in this stock even if you had the vision to look past the clamp down on Jack Ma, trade-war with the US, the regulatory cleanup, country governance risk, variable interest entity (VIE) structure, and other uncertainties.

Sure, you might need to track the stock and wait for months or even years. Sure, you miss out on some gains because you had waited for a confirmation of a bottom, but imagine also missing out on heartache, anxiety, doubt, and opportunity cost because the capital is deployed on other companies with stronger momentum that kept on compounding.

Now that we settled the first question, why do we need to consider the second question on the markets as a whole? Furthermore, isn’t it known that no one can perfectly time the markets?

No one can predict the stock market!

While it is true no one can predict the markets with 100% accuracy, sentiments of the market are not completely random. You just need to know what to watch out for.

Knowing some of these indicators can help identify where the market sentiments are at right now and how to use these cues to decide our overall portfolio strategy e.g., when to put more or less money to work or when to risk on / risk off through hedging or asset diversification.

Yield Curve, Feds Fund Rates & US Inflation Rate

The first thing we can track is the yield curve. Every inversion of the yield curve is always preceded by a market crash within a 6-18 month timeframe historically. A yield curve inverts when it cost more to borrow for the short-term than it would for the long-term.

This can be tracked by a 10Y-2Y Treasury yield spread, which shows the negative spread and yield curve officially inverting in July 2022.

An increase in the cost of borrowings then results in the slowing down of expansion plans which then reduces growth rates on the company’s financial statements resulting in a lower intrinsic value and hence triggering a sell down.

Image of S&P500 (SPX), inflation rates (USIRYY), federal funds rate (USINTR), and 10Y-2Y US Treasury yield spread (T10Y2Y)

However, why does the short-term yield increase in the first place?

The federal reserve indirectly controls the short-term interest rates to spur or dampen economic activity, to control the rate of inflation of goods and services in the economy and its supply and demand.

Cheap borrowing results in more cash borrowed and more purchases of goods and services. With more dollars chasing a limited supply, the price of goods and services increases resulting in inflation.

Some amount of inflation is good. After all, who does not look forward to that a yearly increment, but that needs to come from somewhere! However, if inflation increases too high too fast, civil riots will ensue as things become increasingly unaffordable. Just think back on increase in prices of goods and services this year.

In summary,
  • The federal reserve, with an eye on the inflation rate (USIRYY)’s rate of increase, attempts to
  • Pull the federal funds rate (USINTR) lever to influence the short-term cost of debt to its lenders
  • When that happens, the 10Y-2Y US Treasury yield spread (T10Y2Y) gap narrows to 0 or even inverts (below 0)
  • Which then slows the growth of the companies and its economy and indirectly causes a drop in valuation.

When the market crashed in Jan 2022, the yield curve was yet to invert but the market was already pre-empting the fed’s move for the year when inflation spiked above 7% and the feds started to increase the fed fund rates incrementally.

With the U.S. YoY inflation rate dropping from the Jun’22 high of 9.1% to the current 7.7% in October, it is still way above the 30Y average of ~3.3%. The federal reserve is likely to continue with its plans to raise interest rates from the current 3.25% to 3.75-4% end of November and up to 5% in the 1st quarter of 2023 until the inflation rate drops further.

At VI Fund Management

To roughly know when the market might show signs of letting up, we keep an eye on the reversal above-mentioned indicators (starting with a drop in inflation back to average, etc..), together with a plethora of other financial and economic indicators the feds might look at to keep tabs on the market and confirm them with mid-term price sentiment on the indices.

As it stands, dollar cost averaging over the next 6 months across a robust portfolio of stocks should already enable investors to do reasonably well over the next 3-5 years. However, with a few more tools added to your arsenal, I hope you would be able to sharpen your investment results and provide get clues as to where the market sentiments currently stand.

To a successful long-term compounding journey,
Joshua Zhang | Investment Manager, VI Quant Series
VI Fund Management

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