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Unmovable Rates, Irresistible Momentum

Video Transcript

Hello everyone and welcome to beat the market. In the next ten minutes or so I'm going to talk about our investment strategy for the week, with my views on the sectors, and the stocks that will be in our systematic global large cap portfolio.

Last week both equities and bonds rallied.

This puts us in the liquidity easing regime, but as ever, this was far from a straightforward week. Bonds may have rallied, but the Jan 25 Fed Fund future sold off hard, meaning that the market is now expecting fewer cuts from the Fed.

This strengthened the Dollar while commodities sold off.

Under the hood, equities paid more attention to the Fed fund futures. My liquidity pricing indicator shows that equity markets were again pricing tighter money last week.

With rates having rallied on the week, at this point I think liquidity is a tailwind for equities.

A return to the liquidity easing regime that dominated Q4 was a bit of a surprise.

At the start of last week I thought that the market would remain concerned about demand for treasuries, continuing the trend for higher rates, and necessitating weak data to support equities. Equities did indeed rally on a weak ADP, together with an increase in jobless claims. However on Friday they also rallied on an exceptionally strong payrolls.

The reason that this happened is that the treasury announced much lower borrowing than expected, as a result of improved tax revenue. Strong gains in jobs and higher tax revenue tell a consistent story, and it is one of strong growth. Reinforcing this story, the Atlanta Fed GDPNow preliminary reading for Q1 came in at 4.2%, and Michigan consumer sentiment had the highest reading since July 2021.

What's not to like?

Well according to BLS data, over the past year, the number of native born people in the labour force is unchanged, but 200,000 have gone from employed to unemployed.

Meanwhile the foreign born labour force has grown by 1.3m people, and 1.2m of them have a job. This is in the ballpark of the number of legal immigrants each year, so I don't think this is about the open border. What it does suggest however is that the US isn't producing workers with the skills that employers want. That's not good for the country long term, but doesn't hurt the stock market in the short term.

Also from the BLS, average hours fell sharply in January so that even with solid hourly wage gains, the amount actually earned was little changed. This could be a result of increases to minimum wages in various states that came into effect in January. That would be consistent with more people taking part time jobs, and the higher jobless claims numbers. However, state level claims data doesn't provide any evidence for this.

Another thing not to like is the performance of Chinese equities.

Unless of course you wanted to see their market fall, perhaps because you sold last week after I said their RRR cut would be ineffective. Korean equities meanwhile rallied strongly, led by their carmakers, who are probably benefitting from recent

demand for hybrids.

The final thing not to like is that even if we take all the US data as good news, the upshot is that rates will stay higher for longer, which only increases the probability that we get a renewed banking crisis. I'll come back to that.

Last week in the sectors I was looking for a bounce to sell in XLY, and in the mean time bought staples against financials. It was mostly a technical story for XLP, while I thought that XLF would be dragged lower by China. That view worked decently well, with XLP among the leaders having rallied to the top of its bull trend channel.

The question then is whether I want to sell this rally in XLY.

Ultimately yes, but for this week I think its better to stay with my short in XLF. The rally in XLY on Thursday and Friday looks to me like people buying as opposed to profit taking on shorts. I think it needs to consolidate a bit more before resuming lower. As yet the financials are not really pricing any spill-overs from the trouble at NYCB and Aozora. This could be because there won't be any, but if it turns out that there are, then we're looking at a substantial move lower.

Against financials I like industrials. XLI closed at a 52 week high on Friday, and I want to follow that momentum.

At the industry level last week I thought that home builders do poorly as rates rose. Instead it was those pesky banks which didn't like the increase in short term rates, while the homebuilders were helped by falling long term rates.

This actually reminds me of the situation in the Eurozone debt crisis. Back then you had monetary policy that was too loose for Germany with their strong economy and inflation phobia, but too restrictive for Greece with their mountains of debt and a lax attitude toward paying taxes that made it difficult to service that debt.

Now we have rates that are too high for some banks and also all the clean energy stocks, but the risk of a banking crisis is sufficient to keep longer term rates in check. The result of this is consistent underperformance from the sectors hurt by high rates, but massive outperformance for others from investment in AI for example. This is a momentum trade, and with rates staying higher for long, it should continue. In particular I'd look for bank stocks to keep going lower.

The VIX moved higher last week, despite the new high for stocks.

The move in the volatility skew says that the rise in VIX was because of demand for calls. I believe that dealers are short gamma to the topside, and are therefore having to chase the move higher. This is probably supportive of equities.

The MOVE index rose sharply as rates rallied.

As I noted last week, traders had been selling options to bet against a rally in rates, so again this looks like someone got caught short and were saved by the payrolls

number. I don't think this tells us much going forward.

Okay next let's talk about our systematic global large cap portfolio.

Last week we stayed in cash, and underperformed by about 100bps as a result. We're now up 5.0% on the year compared to 4.6% for the benchmark, which is the MSCI World Large Cap index.

This week our signal is to get back into the market.

We are rebuying ABNB, TEAM, FCX, URI, AXON and MPWR, and buying new positions in BN, FTNT, CCL and NUE.

The new positions in CCL and NUE are continuing the travel and materials themes that we have with ABNB and FCX, while FTNT is another software company.

BN is in the alternative asset management business. They probably

have some exposure to real estate, but i think this was probably reflected in their stock price performance over the past couple of years. The more recent rally suggests that they have been able to pick up some bargains.

BN is one of three positions that report earnings this week, the others being MPWR and FTNT. FTNT in particular has a history of big gaps on earnings. There have been a couple of analyst downgrades recently however, so I think the chance of another big negative surprise is low.

TEAM just reported earnings and the stock fell about 15% as a result. That's obviously good for us rebuying it, but let's take a look at what happened. TEAM is in the process of transitioning their customers from server based software to the cloud. This transition is taking a bit longer than the market was hoping, with more companies than expected taking the intermediate step of moving to a data centre. I think there's also some concern that if AI allows companies to have fewer IT staff, then the number of paid seats for TEAM could be lower than expected.

For their part, the TEAM just launched their AI offering in December. The video demo on their website is a bit amateurish, so I'm not convinced that this will move the needle much for them just yet.

Having said all that, the company is still growing handily, and with the recent decline, is trading towards the lower end of its bull trend channel, so it doesn't look too bad to buy here.

Among our holdings, I particularly like the look of CCL.

It has one of the highest betas to rates of any stock in our universe, and so has been particularly affected by the recent trend for higher rates. That means we're getting to buy it at an attractive level in the context of its current bull trend. I also see significant

interest in calls on CCL for March.

Also on my radar this week is PLTR. It's not in our portfolio this week, but as with CCL, it looks like a good level to buy to me.

Okay so to summarize, we're long the market this week, with positions in ABNB, TEAM, FCX, URI, CCL, NUE, AXON, BN, MPWR and FTNT.

In the sectors I like selling XLF to fund XLI, and in particular I think banks are going lower.

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