Bidding Farewell to January; What Lies Ahead…

The beach at Manele Bay on the island of Lana’i, where we were fortunate enough to spend the last week, is a wonderful spot. Whales breach just offshore, spinner dolphins play in the waves and the sun is always out. The locals refer to the area as God’s Fingerprint because, no matter what is happening on the rest of the island, Manele Bay seems to bask in perpetual sunshine and glory.

Basking in glory is what the markets did during the time of Janet Yellen’s ruling the Federal Reserve. Similar to our Hawaiian slice of heaven, the markets were bathed in glory during the years of her reign.

Sadly, Friday morning was our departure day. We woke to rain (what?) and headed to the airport where our plane suffered a mechanical delay causing us to miss our connection; our time of bliss was coming to a crashing halt.

Friday was also the first day of the post-Yellen Fed. And, similar to our experience, the markets suddenly fell out of favor with a loud thud.

This week’s newsletter not only reviews Tailwinds’ January performance, but discusses the state of the markets, and how they’ll affect equities, as we enter 2018 – a year that appears set to be much more interesting than the past few. And, while the old Chinese proverb says, “May you live in interesting times”, I tend to think that by year-end we’ll be wishing 2018 was as boring as the prior year.

Equities…expect volatility to increase

Three weeks ago I outlined expectations for all the stocks in the Tailwinds Select Portfolio. I said it was hard not to be exuberant at the prospects in front of the portfolio members as each appeared poised for success, however exuberance needed to be tempered as stocks are not always one-directional.

The month of January could be considered Evidence #1 as an example of good news sending stocks higher and macro-concerns hitting those with no news. In our little portfolio, we had 5 stocks each up between 36 and 74%. At the same time, 4 stocks were down between 20 and 30%.

Simple math says that January was probably very good, based on the aforementioned nine volatile stocks. And, indeed it was, with the portfolio up a record 18% bringing gains since inception to 93%. This was our best month ever, but could have been stronger; performance tailed off dramatically, along with the markets, in the last few days.

Here’s a summation of the big January movers, along with the driving influence behind each move.

As the above clearly demonstrates, stocks with good news still have plenty of upside. It’s those microcaps with a lack of news flow that are suffering in this market.

However, for me, it’s not all about past performance, but positioning for the future. January was great on one hand, but very disturbing on the other. For, while it seems obvious that our stocks are well positioned fundamentally, and not overvalued which means they will move up on good news, the hard hit they took at the end of the month shows that technically stock prices got ahead of themselves.

The market appears to be entering a new phase. Improving fundamentals along with an abundance of cheap dollars coming from the Fed led to the amazing bull market we have seen the last few years. On the positive side, fundamentals appear to be getting stronger. The economy is doing great; tax cuts and an major infrastructure spend will only make it better.

But, the days of cheap money may be best viewed in the rear-view mirror. The Fed has started tapering and that looks like it is just about to really kick in, as wonderfully detailed by the MacroTourist.

Higher rates are certainly coming and historically this is not a great thing for the market. Yet, we all know the market is just a giant discounting mechanism; over time it bases valuations on future earnings and they do look very promising right now.

All of which means that we are entering a vortex of higher rates and less available cheap cash, but a very strong economy leading to stronger corporate earnings. Which leads to…More Volatility.

The VIX, which measures volatility, has been trading at historic lows for quite a while. It’s very tough to think this will continue; the last week has seen dramatically higher volatility. Increases in volatility are often correlated with lower share prices. This week certainly saw some of the VIX increase due to lower prices. However, the cross-currents of economic forces at play will lead a sustained increase.

Expecting higher volatility does not mean that I’m predicting a massive selloff in the equity markets. We are extended and have had a very long run with no real correction; one is due. But, a 5-10% correction is healthy and not something to necessarily fear.

What investors do fear is a crash and I don’t see one happening. When looking at the last few crashes, they were caused by bubbles; while stocks are rich here, there is no bubble in the equity markets.

In the microcap space, Tailwind’s playground, there is even less sense of a bubble. Valuations in a number of our names are quite reasonable and don’t give us pause for alarm at all. This is due to two things; the bear market microcaps enjoyed In 2016 and the overall lack of investor interest in the space.

Therefore, my view of the market is one of a possible correction in the near term, but long term positive on earnings strength. And, an even more bullish view on microcaps; my strategy is to be a scaled buyer on weakness in the Tailwinds’ names and to want to own them in a big way when the market correction has run its course.

A few random thoughts on other markets. 

Bonds…ever watch a bullfight? You know how it ends…

I ran with the bulls in Pamplona a few years ago, a massively thrilling experience that ends with a bullfight in the afternoon. To paraphrase my wife, I saw two bull fights…my first and my last. The event is quite a spectacle. There are riders on horseback, incredibly colorful and shimmering. They parade around the ring to applause, then the bull arrives. He is strong and powerful; absolutely fearsome, he appears indestructible.

Then the riders spear the bull. Multiple times, letting it bleed until it can’t really lift its head. This all happens prior to the matador’s appearance. He is really just there to finish the job.

A bullfight is at first beautiful and majestic and, then, it is gory, bloody and quite sad. And, it always ends with the bull being hauled, lifeless, from the ring.

Well, the matador entered the bond market last year. He is just now down waving the cape and drawing his sword. All that’s left is for the kill shot, if it hasn’t happened already.

I believe the bond market is set to enter a long, slow decline. Higher interest rates are a foregone conclusion. The biggest questions are how strong both the economy and inflation will be in 2018. If they exceed expectations, it could get ugly here. Regardless, rates appear headed higher and I believe this is the biggest risk to the equity markets.

Meanwhile the dollar is sinking…

When last I wrote about the dollar, I said it was entering a bear market. Well, as fate would have it, my bearishness caused a brief rally, but here we are firmly in bear market territory with most analysts now firmly in my camp. There are many factors lining up against the dollar, all of which suggest continued weakness.

First off, rates went higher here before overseas. Now other economies, such as the EU, are starting to raise rates. This is causing a reversal of flows from the US; as other markets get more competitive, funds get repatriated out of the US.

Economic strength abroad is also causing cash to leave the US. This is especially true in emerging markets, but the overall health of the world economy is a direct cause of dollar weakness.

But, the likely biggest cause of dollar weakness is the man in charge of the country. Trumps unique ability to upset almost every other country, threaten trade wars, and talk about not supporting the dollar, is really doing a good job of helping destabilize the dollar’s position as the world’s reserve currency.

Bottom line, while not a major concern for the equity markets, expect dollar weakness to correlate with investors putting more money in overseas equities and less in the US.

Bitcoin…more gruesome than a bullfight…

Back to the beach at Manele Bay for a minute. All the attendants who set up the beach chairs and give out snorkeling gear are long Bitcoin. Oh boy…

Having led all markets in performance two years in a row, Bitcoin was due to come down. However, when the best analogy is tech stocks in 2000, it’s probably wise not to try to pick a bottom here.

If you remember the Y2K tech bubble, everything that mentioned the internet went up. And up and up and up. It was truly insane. Some of these companies were real and some were just grand ideas. But, in both cases, valuations lost all touch with reality.

Digital coins are the exact same. We all know the internet is totally essential to our way of life today. Blockchain is going to be huge in the future. However, digital coins are way out of touch with reality and are on their way back to earth.

I’ve written about ICO’s and why they should be avoided, how Bitcoin is a Ponzi scheme, and called (fairly accurately) the top. So, I’ll not espouse any more on why I think they are going down. I will just say that I firmly believe that Bitcoin, and its peers, are all going much, much lower this year.

The good news is that, I think, no large investors really care and the damage will be contained to a bunch of dreamers who, sadly, lose their shirts. Which means that, for equity markets, I’m not concerned.

The bottom line…

As I wrote this, I suddenly realized that I’m tending towards bearish on most everything. Bonds, dollar, bitcoin…you name it. I am not, however, losing my positive stance towards microcap stocks, especially those in the Tailwinds Select Portfolio.

The economy is strong, valuations of our stocks are not high, and growth prospects look great.

This is setting up to be a tumultuous year and it will certainly be more of a stock picker’s market than the past few years. But, that’s what Tailwinds is all about…stock picking. I remain a steadfast bull on our names and continue to think that this will be a great year for Tailwinds and those who follow us.

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