The Reason I Am So Defensive

Lawrence Fuller

February 6, 2020

I felt very strongly that market and economic fundamentals were going to weaken significantly in 2019. As a result, I expected the bull market to end and a recession to ensue. Therefore, I positioned my model portfolios very defensively, as they remain today, while maintaining a core exposure to each asset class, as dictated by my all-weather strategy. I couldn’t have been more accurate on my real-world outlook, as the earnings recession I expected extended throughout 2019. Yet I couldn’t’ have been more wrong on my market outlook, as the stock market soared. This was largely a monetary phenomenon, as the Fed went from tightening policy in 2018 to loosening it dramatically, which was then followed by a new quantitative easing program.


 In hindsight, I should have been far more aggressive, but I still managed to achieve my investment objective of a 7% overall return through a very diversified portfolio that was continuously hedged throughout the year. I maintained my discipline, and I will continue to do so to meet my long-term objective. I need both fundamental and technical factors to align for me to become more constructive on this market long term, and I am investing with a ten-year time horizon. If I had implemented a similar strategy in 1999 and 2007, I would have performed far better in the 1-2-year period that followed. I won’t repeat my past mistakes. 

Monetary stimulus has had a growing impact on financial asset prices in recent months and years, but it has had a waning impact on economic activity. At this point all I see it doing is further divorcing market valuations from fundamentals, which will lead to tremendous destabilization down the road. As debt has not been extinguished since 2000, but merely transferred from corporate to consumer to government balance sheets, I think an inevitable rise in rates will be what brings this cycle to an end. The catalyst for higher rates is still a mystery, but my suspicion is that it will be what no one is currently look for—inflation. 

As we start 2020, I am even more concerned about fundamental deterioration than I was a year ago, but behind a backdrop of far more excessive valuations. While the bulls say that we are not close to the lofty valuations of 1999, I assert they are even worse using several different metrics. One is the PEG ratio, or price-to-earnings growth. As most are aware, we have virtually no earnings growth, which is why today’s PEG ratio is almost off the chart. Investors are paying an exorbitant amount for stocks based on earnings growth. Bulls will argue that this is justified because interest rates are so low, but I argue that low interest rates imply even weaker growth in earnings. It will take a very long time for corporate earnings to grow into today’s valuations, and a lot can go wrong between now and then.


But I want to focus on some technical factors in concert with the fundamental deterioration on both a long-term and short-term basis that has me particularly concerned after this latest melt up in stock prices. The chart below comes from the NorthmanTrader, who is one of my favorite technical analysts, which depicts the developments in interest rates, relative strength and breadth over the past three economic and market cycles. In my view, it is the most important chart for long-term investors. What it shows is that about a year ago we started to see a pattern like what we saw prior to, or coinciding, with the last two recessions and bear markets.  

The relative strength index (RSI) begins to weaken from extremely overbought levels (top of chart). The yield curve inverts (10Y/3M), signifying economic weakness, only to un-invert, which leads to a subsequent rally to new all-time highs. There was little comment on the fact that it inverted again this past week. The rally narrows as investors pile into the largest cap names, while the broad market continues to deteriorate (bottom of chart). This is playing out all over again, just as it did in 2000 and 2007. 


The deteriorating breadth is what has gone largely unnoticed. The bottom section of the chart above shows the Value Line Geometric Index, which is an equal-weighted index of about 1600 stocks. It peaked in the fall of 2018! I provide a shorter-term view in the chart below.


Beneath these and other behemoths that dominate the Nasdaq and S&P 500 are numerous smaller names that trade at multiples to sales, not earnings, of greater than 10. When I see a stock trading at 10x sales, I’m always reminded of what my father told me in the summer of 2000, during the early daysof the Nasdaq collapse. He said, “never pay 10x sales for a stock unless you comfortable with 80% drawdowns.” He was a growth stock fund manager at the time. I’ve never forgotten that sage advice,but investors seem to be buying these stocks today like they are risk-free assets.

For example, Wingstop Inc. (WING) is a $2.6 billion market cap that trades at 100x earnings and 14xsales. They sell chicken wings. They must be damn good wings. I’ve never tried them, and I love wings, but I’m not buying the stock for a valuation that suggests they have a cure for a horrible disease that plagues a large percentage of the population.

Screen Shot 2020-02-02 at 1.47.26 PM.png

Yet today we have investors piling into the largest cap and most expensive names as though they have cures for cancer. No, Tesla doesn’t have a cure for cancer. It makes electric cars, and it is now at full production capacity of 500,000 cars per year. You would never know it by its market cap, which now exceeds that of Ford (F), General Motors (GM) and Fiat Chrysler (FCAU) combined. Tesla is a component of the Nasdaq 100 index (QQQ). Below is a picture of the irrational exuberance Alan Greenspan was talking about in 1998.


Now let me show you the more immediate concern I have from a technical perspective, which is the rationale for my portfolio hedges being focused on Nasdaq 100 (QQQ) performance over the coming six-month period. Note the negative divergence for the relative strength index (RSI) at the top of the chart below. This index is now approximately 17% above its 200-day moving average, which is the most extended percentage we have seen in the past decade.


It is rare that we see this index climb more than 15% above, or fall 15% below, its 200-day moving average. Every time it has occurred there has been a reversion to the mean, which has been either the 150-day or 200-day moving averages.  This is shown by the NorthmanTrader in his chart below that depicts the past two years.


The pattern persists even when we go back to the early years of this bull market, as can be seen below.


We can even see this pattern persist if we go back to the two years before the last bear market in 2008.


Therefore, when I consider the long-term technical and fundamental backdrop with the shorter-term overextended nature of the leadership names in this market, I must be defensive. Perhaps this time it is different, but that has never been a winning strategy in the past. A reversion to the mean for the Nasdaq 100 to its 150-day moving average would result in a 13% correction from today’s highs. That would correspond with a price of approximately $25 for the triple inverse of this index, the ProShares UltraPro Short QQQ (SQQQ). The hedges I have in place using bull-call spreads on this inverse index will pay out handsomely should that correction occur before June expiration. Meanwhile, I will continue to take profits on stocks that I see getting way ahead of themselves, as I did with IBM (IBM) yesterday.

Disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.

Screen Shot 2020-03-22 at 8.52.50 PM.png