BUILDING ON A SWAMP
7/21/24 Prospero.Ai Investing (139th) Edition (Weekend)
As I write this letter, I'm sitting in my home looking out the window at Galveston Bay. It's beautiful, but there's one problem. My home is quite literally built on a swamp. That's great if you want to have a boat, go fishing, or take a swim, but when it comes to homebuilding-it presents a problem. As you might guess, the number one problem many of my neighbors have is their foundation. Turns out, a swamp is a pretty unreliable foundation to build on. We titled this letter, "Building on a Swamp", because in many ways, that describes what the market is like right now. In this letter we're going to talk about why things are difficult to read right now and give you our Top 3 Scenarios for how this market could play out over the coming days/weeks.
Let me begin by saying that being a good investor or trader has everything to do with recognizing patterns. Once a pattern is found, you create a strategy that best executes within that pattern. After you recognize the pattern and the strategy, you adapt and evolve those strategies in an ever changing market. Sounds simple right? With a firm foundation, it can be. Over the last year, we've had a firm foundation of a Bull Market, riding on the back of A.I., that until recently has been steady as a rock. Maybe that stability returns, but over the last few days those firm foundations have proven anything but firm.
Let me give you two quick examples:
1. Recently, our thesis was that mid/small caps would perform better in the mid-term. There was so much historic and fundamental evidence to build our thesis on. It worked for a couple of days, but the pattern broke because people flew into value stocks. That's a pretty hard pendulum swing in just a couple of days. Small Caps are typically a "Risk-On" type of investment. Value stocks are a Risk-Off investment that people run to when they're tentative. Both of those moves happened in the course of DAYS. So what foundation are we building on? Are we risk-on or risk-off? The answer is; We don't know! Pretty swampy foundation to build on.
2. Here's another example. Taiwan Semiconductor recently reported earnings and they killed it in every way! Yet the stock still went down. Even the strongest predictor of success for a stock (great earnings) wasn't enough to create a Bull day for TSM. Why? Because we're in an election year and there are some pretty volatile forces hitting the daily news cycle; and those forces are completely outside of anyone's control or ability to predict. (FOR EXAMPLE) As I was literally writing this letter, I just learned that President Biden dropped out of the Presidential race. We live in crazy times folks! Pretty dang swampy.
So how do we move forward and build a plan in an environment like this? Based on our numbers and analyzing the data, here are our 3 TOP SCENARIOS for how things could play out in the coming days/weeks:
Scenario #1: It turns out that A.I. stocks were overvalued and the last year has been one big momentum swing that has recently reversed.
If #1 proves true, then we believe a bear market is likely heading our way.
Scenario #2: Wall Street still believes in Tech/A.I. long-term, and they saw these latest highs and the news from last week as an opportunity to take profit, short the stock, then buy back in at a lower price.
If Scenario #2 is true, then this is simply a slight correction and we should be back on track soon (Unless Trump/Biden or some other unforeseen political or macro economic event impacts the market)
Scenario #3: This last downturn was purely driven by Trump's words (on Taiwan) and Crowdstrike's mistakes creating a selling panic. If scenario #3 is true, then apart from aforementioned caveat's of #2, we think Tech and A.I. will have a strong and imminent comeback.
Lastly, here's how we'll approach these 3 possible scenarios. We're going to build a strategy that assumes the worst (Scenario #1) but still captures upside in case Scenario #3 happens. Bottom line, we're going to be extremely conservative, (b/c of potential news events), but still leave room for what has been our core convictions all along, which is that A.I. and Tech are worthy of their current valuations.
A WORD FROM OUR CEO
Well that was a tough one for the books. We will let you know how we will adjust our portfolio management strategy to better suit what we expect to be a new paradigm of increased volatility. We are still having a great year though beating the S&P 500 by 58% annualized, with a win rate of 61% against SPY benchmarks.
For newer readers linking our short intro + learning videos.
Normal streams this week! Monday 7/22 at 11 AM EST and Wednesday 7/24 at 3PM EST.
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BUILDING ON A SWAMP
Market/Macro Update w/ Cap/ Value Analysis
QQQ and SPY Net Options Sentiment
Sector Analysis
How we view the Sector performance and momentum
Portfolio Strategy
Putting it all together to make a portfolio that first controls for risks but also has upside
Longs
Adds —> Keeps —> Drops
Shorts
Adds —> Keeps —> Drops
Portfolio Summary
Market/Macro Update w/ Cap/ Value Analysis
Last week’s Net Options Sentiment levels from the 7/21 letter: SPY and QQQ Net Options Sentiment > 50 = Bullish < 40 = Bearish.
Well these levels were one of the things we did right last week. They were helpful in showing that there was a break from the Bull momentum. We should have flipped more Bearish instead of closer to neutral.
In the intro to the letter we outlined our 3 most likely scenarios for the coming days and what strategy we plan to implement. In the Market/Macro update, I want to show you two pieces of information (one bearish, one bullish) that visually demonstrate why we find ourselves in such an uncertain market. Check out the graphic below (chart via @trendspider).
For those of you that are new to technical analysis, this is the QQQ Monthly Chart. Each one of those candles represents a month. The top and bottom lines are what's called a "Trend Channel". The stock price of QQQ, has so far risen and fallen within those trend lines. Notice where the last monthly candle is? At the top of the trend line….and it's red. This is typically a sign of a QQQ reversal. Of course, Tech earnings start in earnest this week and if earnings come in higher than expected, we could potentially see a bullish continuation. But from a pure technical perspective (as well as our QQQ numbers that you're about to see), things are looking pretty bearish.
On a bullish note, check out the graphic below (via @sethcl).
This is a graphic depicting the RSI (overbought or oversold conditions) of SMH (Semiconductor ETF). The last 5 times Semi's reached this level of being oversold, there was a STRONG upward correction. My point is that there's mixed signals in the market and it's impossible to know which direction we're ultimately headed. Last week's QQQ Net Options Sentiment clearly shows a downward trajectory. This week will hopefully bring some much needed clarity.
CAP/VALUE ANALYSIS
See the above table. If you look at the weekly numbers for Large Cap Growth, it clearly had a tough week. You can also see that it was the one area that had a negative month. While that's bad news, we do see a broadening into the other areas. Overall, Small Cap Growth had a good month, but Small Cap Value had an even better one. When you combine that with the type of month that Mid and Large Cap Value had, you can certainly see a pattern emerging. One of the most interesting things for us to watch over the next couple of weeks, is whether Small Cap Growth, or Value stocks take a clear lead. They both send very different signals to the market.
NET OPTIONS SENTIMENT
See the above chart. Toward the end of the week, we saw a rapid downward movement in our QQQ Net Options Sentiment. As we shared earlier in the letter, it's hard to tell whether that was a one off event based on rogue political comments and data breaches, or whether it's the emergence of a concerning trend. On Friday we saw our QQQ numbers dip extremely low (briefly into single digits). By the end of Friday, we saw a slight recovery and ended the day at somewhat respectable 38. We'll be watching closely on monday to see if options sentiment and QQQ price trend can reverse.
See the graph above. Our SPY Net Options Sentiment numbers are showing mixed signals, but are holding up slightly better than its QQQ counterpart. This could be a positive sign that the market is broadening. Regardless, the fall in sentiment has us a bit concerned about a clearly bearish momentum. We're in one of those seasons in the market where monitoring these Options Sentiment numbers become extremely important. After one week of adjusting to more Bullish levels we will return to the lower, more sensitive levels we had the previous weeks.
SPY and QQQ Net Options Sentiment > 40 = Bullish < 30 = Bearish.
SECTOR ANALYSIS
See the sector analysis linked above. We hate to say it, but if you forced us to choose a bear target based on this table, we'd have to pick Tech. It had a ROUGH week and a clearly bearish month. But as shown in the SMH graph above a case could be made that it is ready to turn around. On a positive note, Energy, Real Estate and Financials continue to show strength. Whether or not this is a full fledged Sector Rotation is too early to tell, but the data continues to point to at least a broadening of the market.
PORTFOLIO STRATEGY
Hold onto your hats. We are going to be doing things very differently this week. A big issue for us last week was things were changing too fast and we didn’t have time to do the proper research to diversify and test theories in this new market filled with twists and turns. So this week we are starting out with a large portfolio of 13 longs and 13 shorts (but we will overload SMCI per an event driven strategy below) and we will quickly eliminate the stocks that aren’t working. This will be done with chat updates for our paid users. As much as we’d love to give you a portfolio that we hold for the whole week as we try to do most weeks we do not think that is realistic right now. But we are offering 40% off becoming a paid user to make it easier to follow along!
Long / Bull Moves - Link to Below Picture
Long / Bull Moves - UNH, AAPL, LIN, TMDX, CLSK, APLS, TSLA add / META, BKNG, ASPN, SMCI (4 of 6 positions), ROOT, AMSC holds / LLY, AMR, SRPT, KKR, CNK drops
You may notice this has changed, intead of the technicals on the right we are rolling out our new signal Technical Flow. Which aims to sum up all technicals into one number and we will be leaning on it more!
Adds
TSLA is something we’ve been talking about on our streams. As Trump looks more likely to win and Elon and Trump buddy up more and more, it is hard to not be Bullish on the stock. AAPL was added because it was the best tech stock without elevated Short Pressure or Dark Pool and we wanted a way to get exposure to a potential Tech recovery outside of chips / SMCI. LIN we liked for its great screener performance, diversification and impressive Technical Flow. TMDX, APLS and CLSK were the best Small/Mid Caps in our Screener and we want to continue to make sure we are making a play for breadth.
Holds
First let’s talk SMCI, you may have been thinking has George gone crazy adding 6 positions? Hopefully not. SMCI is getting added to the QQQ tomorrow and 64% of the time that happens the stock is green that day. Seeking Alpha also reiterated a Buy this weekend, interesting timing… We thought it got hit around the news last week and we bet on it more than any stock in our portfolio ever because of that. We did pair it back a little though cutting 2/6 positions. META and BKNG were easy holds. ASPN, ROOT and AMSC were held because even though their price got hit their Upside and Net Options Sentiment held up and we think this makes them candidates for recovery.
Drops
LLY was dropped because we didn’t want too large cap tech and UNH just looked better. We also liked LIN better than AMR. SRPT was just too low in Technical Flow. KKR as a finance stock getting filtered out was too risky for us and CNK and SEDG did not perform well enough in the Screener.
Short / Bear Moves - Link to Below Picture
Short / Bear Moves - JNPR, HQY, IPG, AAL, LSCC, PVH, F, CTLT, LSXMK, AMP, GPN adds / LPL, F, MGA holds / EXPD, ACI, ON, CVAC, AVA, WK, MRVL, QCOM, APPN, IAC, BAX drops (*Note APPN, IAC and BAX do not appear here because we did not generate a Technical Flow number)
Adds
Ok so we can blanket a lot of these adds by saying pretty simply they were picked as the largest cap shorts we could find with good Screener performance that hedged our long positions. Each and every one was covering a Sector we had long exposure to. And if we had 2X or more we ensured we had more coverage IE Tech.
Holds
LPL was held to increase our Tech hedge. And we do have 3 Consumer Cyclical stocks relative to 2 longs because this was our biggest target Sector for Bears. That is why we kept F and MGA.
Drops
3 were dropped because we didn’t generate a Technical Flow number and we wanted to lean into that signal. EXPD and ACI were dropped because Technical flow was too high. We did add CTLT with a similar Technical flow but that was because we wanted another Healthcare stock and it was the best one we saw. Vs EXPD where there were many Industrials stocks with better profiles and in the case of ACI we were not as interested in the Consumer Defensive Sector, mostly because we were ensuring any Sector we had exposure to Bull and Bear and there weren’t any interesting Consumer Defensive Bulls.
Portfolio Allocation
13 Longs: UNH, META, BKNG, AAPL, LIN, TDMX, CLSK, APLS, ASPN, TSLA, SMCI (4X), ROOT, AMSC
13 Shorts: JNPR, LPL, HQY, IPG, AAL, LSCC, PVH, F, CTLT, LSXMK, MGA, AMP, GPN