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Hi everyone and welcome back to The Spark Newsletter! There has been a lot of market turmoil over the past two months while I was away, but I hope you were able to remain calm and put the things I have written about into practice. Those who have signed up for email subscription were provided with weekly updates on the portfolio and any position changes, so don’t forget to sign up here, as this is the only updates I will provide weekly going forward (articles posted on the website are every fortnight).

In this week’s article I will discuss:

- my opinion on market direction

- How probability is used when investing

- Bear market rallies

Not Out of the Woods

One of the most important things to remember when investing is that price should not dictate your view on markets. The S&P 500 rallied almost 19% from its low of $3635 to its most recent high. Many investors may believe a rally of that magnitude means a new bull market has begun. In my opinion that is not the case.

While I took a step back from writing articles over the summer, I made several changes to the portfolio and its rules, one being that I can now short stocks as well as going long (buying). Although The Spark portfolio is outperforming the S&P 500 (its benchmark for performance comparison), I was unhappy to give back the 8% gain I had made earlier this year. Shorting will allow me to protect my gains by offsetting the risk in the portfolio.

By shorting a stock you are betting on the price falling rather than rising. This is a risky strategy as stocks can only go to zero, so your maximum gain is 100%. On the flip side, stocks can theoretically go up an infinite percentage, so your loss is therefore infinite. For this reason, I will use shorting very sparingly and will set strict stop losses for my short positions, so in the event I am wrong I can limit my downside.

So why is this relevant today? Because I believe the major stock indices are going to fall further. The rally in major stock indices thus far has killed many short sellers who would have to cover their positions, fuelling this recent rally further (when you close a short position you have to buy the stock back). The fall in US inflation marked a turning point in markets short-term and some investors believe this will lead to looser central bank policy. The Federal Reserve (Fed) Chair Jerome Powell confirmed in his speech on Friday at the Jackson Hole conference that would not be the case. He stated that the Fed’s main goal was to bring inflation down, even if that leads to negative consequences for employment and the wider economy. With US inflation at 8.5%, the S&P 500 only 16% below its all-time high, and nothing in the financial system breaking (yet), the Fed will be encouraged to continue tightening policy.

The Housing Boom is Over

We are already witnessing the negative impacts of higher interest rates with recent data from the US. New home sales fell 12.6% in a month, marking the largest decline in over six years.

A fall in home sales is a leading indicator of a fall in home prices. The Real Estate market in the US is worth approximately $3.7trn and you better believe a fall in this asset class will have a ripple effect throughout the economy and the markets. The doubling of mortgage rates in a year is starting to hurt demand, and this is only going to get worse as the Fed continues to raise interest rates.

The situation in the UK and Europe is even worse. Energy shortages are causing huge increases in bills for businesses and families, and inflation continues to rip higher. High energy costs will destroy demand and consumption as disposable income falls. This comes at a time when the central banks are raising rates as well. These circumstances do not bode well for risk assets.

On the other side of the world, China is continuing with its draconian lockdowns and mass-testing agenda, which is affecting global consumption and supply chains. Inflation in China is low (2.7% as of July), so they are cutting interest rates and printing money to stoke demand as the country’s property market continues to falter.

Odds Against Us

For the above reasons, the probability of the stock market continuing its recent rise is low. But how bad will the recession be? I am certainly not smart enough to answer that, but I am sure that the odds are not stacked in my favour if I take unwarranted amounts of risk. The photo above is a simple way to explain my point. For the maths geeks out there, this is a normal distribution. The yellow line shows a simple bell curve, which suggests an equal chance of making and losing money. The red and green lines are skewed, suggesting a higher chance of making (green line) or losing (red line) money.

Everything in investing comes down to probabilities. Nothing is certain in financial markets and there are two types of people that lose money when investing, those that know nothing and those that know everything. I believe the red line best depicts the situation today. Due to the reasons discussed, I do not see it as probable that investors make money buying risky assets like tech stocks or crypto.

The same concept can be applied to the purchase of individual securities. Buying an overvalued stock could be depicted through the red line. The likelihood of making a positive return is low, and the probability of a loss is high. As an investor, I want to have a probability distribution more like the green line by purchasing attractively valued, good-quality companies at the right times in the economic cycle (to the best of my ability).

The covid crash was different from other crashes as it fell and recovered quickly. Traditionally, bear markets are riddled with sharp rallies (see above) that lure in investors whose views are based on price action and crush short sellers who use too much leverage. As the investing legend Stan Druckenmiller said in a recent interview, if your short ‘you can get your face ripped off in bear market rallies’. Cumulative buying at the top and selling at the bottom in the 2008 bear market would have led to an 80% loss, so it is vital to remain calm and not overtrade in a downturn. The recent rally in markets has no doubt sucked some novice investors into buying, as they fear losing out on gains.

I will remain defensive until the final stage of this bear market, where panic and forced selling ensues. The average length of a downturn is around 340 days. We are six months in so it could be 2023 before we witness the capitulation which will mark the market lows. Once this occurs I will not hesitate to use the cash held in reserve at present.

***Portfolio Return Year-to-date: -2.1% vs S&P500: -15.4%***
***Total Return since inception (20/09/2021): 3.7% vs S&P500: -6.9%***

Let me know your thoughts by emailing me at thesparknewsletter@gmail.com

See you next time,

Peter

Disclaimer

This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.