Editors’ note: This is a transcript version of the episode of Alpha Trader that we published earlier this week. We hope you enjoy.
Aaron Task: Welcome to Alpha Trader. We are one week away from the election and in the sick of earnings season a 170 S&P 500 companies reporting this week including Apple, Amazon, Facebook, Microsoft, Boeing and Caterpillar. We also have third quarter advanced GDP numbers coming out on Thursday, shaping up to be a very big week in the markets.
Coming up on the show Chris Zaccarelli. He’s the Chief Investment Officer at the Independent Advisor Alliance, which has $4.5 billion of assets under management. He says, “Now’s the time to begin investing in those companies and industries that will eventually revert to the mean in terms of earnings.” We’ll talk much more with Chris coming up and see what he means by that.
But right now, we are joined again by Scott Bauer, CEO of Prosper Trading Academy. Scott, welcome back to Alpha Trader.
Scott Bauer: Thanks for having me. Really happy to be back here.
AT: It’s great to have you back. And as I said, we’re a week away from the election, COVID cases are going up, earnings season we’re in the thick of it. What is your sense of the state of the market, the U.S. stock market I should say, as we’re talking right now, Monday morning?
SB: I think it’s trading so psychologically, right now, as opposed to off of fundamentals. And that’s just because of the election coming up next week. And what’s going to happen with stimulus. And in reality, at least based on history, in reality, it’s irrelevant, who’s in the White House? Democrat or Republican, the market does what it’s going to do.
Now, over time, if you just broke it down over time the market and again, I’m not talking about the economy, right. Now, I’m just talking about numbers in the market. The market does slightly better when a democrat is in the White House. But the bottom line is, it’s really irrelevant.
So there’s so much uncertainty over the election and so much uncertainty as to who is going to be, which party is going to be better, not just for the market, but for the economy, that’s kind of how things are trading right now. I actually think any pullback that we see here is a really good longer term opportunity.
Are we going to get some kind of snap market move like we did four years ago, with that overnight move after it was announced that President Trump had one? I don’t see that happening at all. I do think that any sort of pullback that we get, though, is really a buying opportunity. Because fundamentals of the economy are I wouldn’t say they’re really strong, but a base is being built.
And once we get hopefully, for everybody sooner rather than later on the road to recovery, on the road to being post pandemic, I think we got a great thing going for us from the economic side of things.
AT: Oh, that’s interesting. We can talk more about that for sure. Because as we’re talking, I’m thinking to myself, yeah, for all the negative headlines and the uncertainty, and obviously the COVID case numbers are going up again, and that’s scary and unsettling. The markets held in extremely well.
I mean, we’re still above 3400 in the S&P 500. And, we were down a little bit last week and starting off this week, as we’re talking to you again, Monday morning, down around 1% for the down the S&P, the NASDAQ’s barely unchanged. And I don’t want to oversimplify things, but it’s just the fact that, hey, the Fed has told us they’re going to keep rates at zero for another couple of years.
And there’s going to be more stimulus coming, whether it’s small, medium or extra large depending on the outcome of the election, but there’s going to be more stimulus.
SB: Yeah. And that’s the point I agree with the — well, I agree with a lot of the points. That’s the one I agree with most, whether we get stimulus prior to the election in 2020, or in the first quarter of 2021? We’re going to get it. We are absolutely going to get it.
So that combined with the fact that, yeah, the Fed has said they’re not raising rates. We have seen rates tick up over the last couple weeks higher into the range that it’s traded in over the last six to nine months, but they’re not going anywhere. So yeah, you have the underpinnings here, that there is just massive support for the market.
Stephen Alpher: And I’ll just let our listeners know that Scott was with us back in mid July, when the market was kind of maybe treading water a little bit after its big run from March and he said, not to worry. We’re soon going to see new highs in the S&P 500. And I would stick with the big mega cap tech names that have led us lead us out of that, out of the bear market, March proved to be a pretty, pretty nice call.
I wanted to ask you about a possible third prong of the bullish outlook. And that’s a vaccine. My thinking or not necessarily my thinking, but some of the thinking I’ve heard is like, the risk is to an explosion to the upside if some sort of a vaccine gets announced sometime in the next two, three months.
SB: Yeah, I agree with that, though, I don’t want to put it in as a buy the rumor sell the news type of event, like we see with earnings reports, or let’s say with an apple, you know an apple day where people are buying up ahead of time, and then the news comes out. So I don’t want to say that, that is what I believe is going to happen when a vaccine is announced.
But I do think that the upside is where the risk is, because if we do get a vaccine, and maybe just as importantly, therapeutics that everyone can use, not just one in 1000 people, but that everyone can use, then all of the stocks that have lagged the broader market, especially in travel and in the like, these stocks are going to start exploding.
And consumer confidence which surprisingly has held in there through the pandemic is probably going to skyrocket. And so, I do think the risk is to the upside. I think, in general, maybe we have a 5% to 10% risk to the downside of the market. But we could easily see a 20% explosion to the upside.
SA: Now, is there a way that you’re thinking of playing that via options or futures?
SB: It’s very difficult right now, right, because so much of it is timing related. I could be right but have the timing wrong. And not have a winning position on that. So in general, what I have been doing is most of my market positions, not individual stock positions, because that’s a different story. But most of my market positions, whether it’s in, let’s say, the triple QQQs, or SPY or even, a trading volatility is leaning slightly to the long or the upside.
But again, it’s very difficult to time because, what if I have a position going out to January, and we just kind of sit here, the market holds in here, and then we get news February 1st, right. So it’s a little bit difficult and in terms of just holding a long futures position, that’s not something I would advocate for right now.
It’s so difficult because every trader wants to time, the market, right? Everybody wants to have that perfect timing, and it typically just doesn’t happen. So, I think the biggest thing that traders and investors alike can do is have patience, and not try and go out on a limb and say, Oh, I know this is going to happen next week, or I know this is going to happen by the end of the year.
So again, I am leaning most of my positions to the upside to the bullish side, but I’m always protected. I always know where my stops are, I always have spreads on. So I’m also maximizing any sort of or minimize any sort of loss that I can sustain.
AT: So I’m curious, Scott, how are you positioned in the very short term, given the fact we have 99% — 99.9% sure, there’s going to be an election the week from Tuesday. Never Say Never, right? There’s going to be an election and we’ll have some kind of results whether confirmed or not on Tuesday evening.
And we’ve talked on the show a couple times about how the expectations were for a big jump in volatility after November 3. A, has that come in at all in the last week or so? Is the poll seem to be moving again more towards Biden, or, and how are you positioned vis-à-vis volatility right now?
SB: Sure. So it’s a lot different than it was two months ago. Two months ago, as we saw on the marketplace, there was a big skew to the upside in volatility post election. That has come crashing into line over the last few weeks. Where meaning, if you look at the volatility markets, if you look at the VIX, there’s no not a big upward curve any longer going out in the future. And that curve was there because, there was so much talk and so much thought of about a contested election.
And what would a contested election mean for the markets, while the markets doesn’t — markets don’t like uncertainty, bottom line, whatever that uncertainty is, like uncertainty. That’s why you saw VIX futures going out to the end of November, December even into January so much higher than then the current VIX futures. That has come into line.
Now, that is trading almost within the range of what normalcy would be. So I have been a seller of volatility any place I could over the last few weeks. Selling volatility doesn’t necessarily mean I’m bearish or bullish in the market. It just means I’m trying to sell premium to let the markets just kind of settle in.
It’s now getting to a point where I don’t know that I want to sell volatility anymore, I don’t want to buy it. I definitely don’t want to buy it, because historically, it’s still very high. But seeing the VIX come into line and the futures predictions come basically flatline here, it’s kind of fair value right now. So unless we do get, unless something happens in the next eight days, that will signal that there is going to be a contested election again, I think we get the results. And I think we see volatility crash.
AT: That’s very interesting. Because, again, it doesn’t make as good a headline, but the idea that maybe do nothing on volatility here or it was extremely overbought I guess, and now it’s come back down norm more into line. And the VIX I think is elevated for a reason. Right.
There is election uncertainty and election, and there are these COVID case numbers starting to spike up, and so, you wouldn’t think that the VIX would be sub, in the teens right now anyway. Right. So you’re saying…
SB: No, absolutely not in. I’m sorry.
AT: You’re kind of saying, I’m just going to, you’re kind of saying that it is kind of around where it quote unquote, should be given the environment we’re in right now?
SB: No doubt about it. And, what many people don’t really understand is what the VIX really measures, right. You hear it on TV, you read about it, and everyone kind of knows it as, it’s the fear factor, right. But what empirically, mathematically, what does it really mean?
Well, I’m not going to go into the big detailed math. But if you take what current VIX is trading at let’s say, right now rounded off, it’s trading 28 29. Okay, if you divide that VIX number by 19. And I’ll explain in a minute why. What you get is the percent move, the daily percentage move in the S&P, or what that equates to. Okay.
So right now, with the VIX trading 28ish or so, that equates to about almost a 1.5% daily move in the S&P.
SB: That’s kind of what we’re seeing. The numbers don’t lie. The numbers don’t lie. It’s supportive, the VIX trading here in the high 20s is supportive of the market moving a percent and a half every day. When the VIX was trading, let’s call it, in its more normal range long term historical range of mid teens, let’s call it 15, that equates to less than 1%, about a three quarters of a percent daily move in the S&P.
So the VIX numbers, they don’t lie. They are an indication, they are going 30 days out, they are an indication, but it’s really trading fair with how the market is moving right now.
AT: Right. Well, I really appreciate that explanation. And just to put or maybe a finer point on is like in the media, and I’m a journalist, we often talk about volatility as the market going down. It’s not just negative volatility. It’s the market moving up and down. And the ring…
AT: In which it’s moving. That’s the VIX, what the VIX is describing and then I think you just did great mathematical explanation, which I really appreciate. And I appreciate you sparing us the deeper math.
SB: The real quick skinny is if you take the square root of 365 days in a year, that’s roughly 19. That’s the math behind why we’re seeing 19 there.
AT: Okay. That I could see, Steve maybe you can handle that.
SA: That’s something I can understand yeah.
AT: I can understand.
SB: Is simple math, easy math.
SA: I wanted to just move on to one other asset. You were with us about 11 months ago, quite bullish on gold when it was $1500 an ounce. COVID certainly wasn’t in the news, then. So whether you were smart or lucky or both, it was a super call gold subsequently got up to about $2100. It’s been a bit of a bear move since roughly then sometime in August. It’s going for about $1900 now. What are your thoughts on the yellow metal at this point?
SB: It’s hard to be bearish. I wouldn’t say I’m overly — I’m as overly bullish as I was a while back. It’s hard to be bearish. Again, there’s so many tailwinds for the commodity space, for the gold market itself, that it’s almost as if there’s is we would talk about the Fed put being in the market for the general market. There’s almost a Fed put in for an asset like gold as well, given the fact that rates are not going anywhere.
The likelihood of additional stimulus is there. What percentage is 50 70 90? I mean, I think it’s pretty high. All of those are bullish for gold. And again, regardless of who wins the election, much of the risk sentiment that we have seen in the world over the last 18 months is not going away. So, yeah, we may see fluctuations here, 2% 3% moves here and there which for gold, those are big moves.
But I think that the absolute general trend is still to the upside. I don’t see the volatility, I don’t see the veracity of it, like the major moves that we saw earlier in the year but kind of hard pressed to be bearish at all in that space.
SA: And Scott, I’m curious if you have a view or a position in crypto currencies, particularly Bitcoin, which is traded back above $13,000 in the last few days, which rightly or wrongly some people are attributing to a flight to safety hedge against election risk or COVID risk, an alternative to the dollar, you know, all these things. What is your take on Bitcoin there?
SB: Sure, and I do trade it here and there, I’m not an expert by any stretch of the imagination. But, when you look at the correlation that Bitcoin has had specifically to the dollar, it’s starting to make a case, just like gold moves inversely to the dollar typically. It’s starting to make a case that Bitcoin really on data now is doing the same thing.
I think it’s still incredibly, incredibly highly speculative. But the longer that you see the dollar kind of flatline and pressure on the dollar decrease and see Bitcoin go up. And then when the flip has happened, when we’ve seen a stronger dollar and Bitcoin sell off, the more you really have to take that data as Okay, historical information here. That’s some really good fundamental analysis.
So I do think that’s why we’re seeing a surge in Bitcoin. I do think there’s a surge there because of election uncertainty. But I am not wanting to say out, the Bitcoin bulls are back and we’re going right back to those highs of whatever they were 20,000 or once the election is over, all right, the luster is kind of gone and we’re going sub 10,000.
SB: But I think it’s very interesting to look at the correlation between Bitcoin and the dollar.
SA: Great, and it’s got to be before that you mentioned earlier, you made reference to your individual stock positions, can you talk about individual names that you own here and I got a sense that these were more intermediate to longer term investments. But I could be wrong about that as well. What can you tell us about your individual holdings?
SB: So number one, I don’t trade from an investment perspective. I let my professional investment manager do that, because I learned long ago that I will mess that up. Because if I have an investment portfolio, being a trader for doing this for 30 years, I’m going to treat it as a trade and I will absolutely make the wrong decision, in terms of trade though.
I mean, I’m just telling you the truth here. When I left my investment professional handle that. In terms of trades though, it’s still to me really hard not to like big tech, and I know this week is humongous with Thursday here with all the fangs except for Netflix reporting and Microsoft reporting, I think on Wednesday, it’s hard not to like big tech.
To me, it’s still really hard not to like the stay at home stocks, who have now become a household name. The Zooms, the Pelotons. Okay, some of the other ones. I think they’re kind of losing a little bit of the momentum, but the ones that have become a brand name, I think are here to stay. One, I really like is DocuSign. I think that one, regardless of when we have re-openings, and people are getting back together and again, I hope to get in sooner rather than later, I think that’s one where that technology is absolutely here to stay in.
And, quite frankly, Zoom like, what we’re doing right now. And I know they have so many challengers coming up and so many competitors coming up, but that is the brand name, and I love the leaders in the space. I love the brand names.
AT: And just to be clear, you have positions in those names?
SB: I do have a position in Doc. These are option positions, these are not stock positions, by the way.
AT: Got it. Okay.
SB: These are option positions. I do have a position in Doc. I do have a position in Datadog, which is another one I really like. That one has kind of been all over the news. There were some famous people around on social media really talking about that one for a while. Those are the only two that I currently have option positions in.
But I’m looking to absolutely take long positions probably ahead of earnings, ahead of Thursday, in many of the others.
SA: All right. So you would take positions ahead of earnings because again, that’s a constant theme here too is like, how do you trade earnings? There’s so much volatility around them. Obviously, the options give the opportunity to do that. Can you describe a trade that you might do heading into the big tech earnings this week?
SB: Sure. I love playing volatility, trading volatility on earnings, not just buying straight calls and puts I never do that, ever. But let’s say I was long — I want to get a long position in Apple. Okay, just as an example. What I would probably do is buy some diagonal call spreads. What does that mean?
It means sell a closer dated, upside call strike. So an Apple may be the 1.25, let’s say. And then by further out, whether it’s weeks or months out, an option with much, much, much lower implied volatility and a lower strike. So basically, I’m buying myself time and I’m buying myself direction. That’s the way that I typically will trade into earnings is trying to combine direction plus volatility.
SA: All right, Scott, thank you. As always, our guest has been Scott Bauer, CEO of Prosper Trading Academy. Thanks for being with us.
SB: Have a great day. Thanks for having me on.
AT: Thank you, Scott.
AT: All right. Stay tuned, we’ll be right back with more Alpha Trader.
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AT: Welcome back to Alpha Trader. We are joined now by Chris Zaccarelli. He’s the Chief Investment Officer at the Independent Advisor Alliance, which is an SEC registered RIA with about $4.5 billion in discretionary assets under management, and over a 100 advisors in 14 states. Chris, welcome to Alpha Trader.
Chris Zaccarelli: Thanks for having me.
AT: Thanks for being here. We’re speaking a call late morning on Monday. And the markets are the sell off is picking up a little bit of steam here. There are more than 2%, S&P around 2% as we’re talking here again, Monday. What is your take on the immediate state of the markets here? Obviously, we have the election in a week, COVID numbers are climbing, we’re in the heart of earnings season, what is moving the markets from your perspective?
CZ: Well, definitely, we’re seeing that risk off tone as you mentioned. But for us, we’ve really seen what’s moving the market higher has been the Federal Reserve with a lot of liquidity injected into the system. And then to a large extent the federal stimulus that was put into the system earlier this year. So, a lot of the market is still looking to see some type of federal package with Minuchin and Pelosi going back and forth.
We’ve been pretty skeptical that some type of agreement could be reached prior to the election. So we’re not that surprised that there’s not going to be anything before that. But we very much believe you will see something in 2021. It’s possible in the lame duck session. So to the extent that the market was looking for some type of a stimulus package prior to the election, clearly the disappointment around that is leading to a little bit of a sell off.
We’re also seeing a pickup in COVID numbers, as you mentioned. And so it’s interesting, there’s a lot of known unknowns out there, both in terms of the stimulus package, in terms of the potential for a second wave of COVID. And then, lastly, the election itself. And so really the markets, it’s gyrating a lot on those three factors. And I think that explains a lot of what the volatility that you see today.
AT: Right and you in your commentary, you’d written that volatility like to pick up in November, as we get close to the election, as well as for at least a week after the election. In our prior segment, we were just talking with Scott Bauer, who had noticed that the premium volatility had come way down in the last few weeks prior to the election.
There had been an expectation a couple of months ago, where a fear that there’d be election and contested election, and there might be a spike in volatility, that premium come off. Are you saying would you be buying volatility here? And or are you anticipating some kind of uncertainty around the election so that we might be seeing another spike in a week or so?
CZ: So, as far as volatility goes, I think there was that nightmare scenario that a lot of people were talking about in the last couple months where you have a constitutional crisis or you have a situation where the results of the election are unknown for more than a month and potentially you have the electoral college which is supposed to meet in December still being pushed by what happens with results from court cases.
And so, if you saw in my notes, the idea is that with so many absentee ballots being cast and if you look, I think it’s we’re up to something like 60 million Americans have voted early already, which that doesn’t include — that includes absentee ballots. But with a lot of early voting and a lot of absentee ballots for those states that need to count those votes after the election.
It’s possible regardless of how wide Biden wins, given that there’s plenty of a swing state in play. It’s possible that even if Biden has a pretty convincing victory, we may not know the results of that convincing victory on November 3 or November 4, let’s say, it could take a week. Now to the extent that the election is a lot closer than people are talking about.
And we really do have a number of states which are critical for deciding who wins the election. And then you have either President Trump or Vice President Biden challenging those results on a state by state basis. That’s where you could see some uncertainty dragged on for more than a week. Whereas I think a lot of people thought that was a very likely scenario, clearly, that scenario has been deemed a little bit less likely.
So you saw implied volatility very, very high a month or two ago, some of that’s come off, because I think people are less worried about really that nightmare scenario where at last week’s if not into December. So at this point in time, I do think vol is still a little bit elevated. I don’t think it’s enough to buy, excuse me, I don’t think it’s enough to sell at this point. But my feeling, but my general feeling, at least looking at the markets is that, a lot of the fears that were priced in have come off. It’s very likely that we see a lot more of that come off.
But it’s really too close to call, given what happened in 2016. And where the polling was off by so much, it’s very hard to take his fact that Biden is going to run away with this, it can be a lot closer than we think.
SA: Right. And to your point, it’s not a zero risk possibility that there is some kind of contested election, now you can test it just uncertainty over the results, because of the absentee ballots and the mail-in ballots in some key swing states. So we might not know for a few days after November 3.
CZ: I think that’s right. I think that’s right.
AT: So how are you positioned? And how are you advising folks in the Independent Advisor Alliance, the financial advisors you work with, to position ahead of that?
CZ: So for most of this year, we were really focused on just good quality companies that have strong balance sheets, pretty good moats around their business. It did help that a lot of those companies fell into those types of sectors that have benefited from the work from home, and the home schooling type of scenario we found ourselves in.
So in general, we were kind of coming at the fall from a position of strength in terms of our investment performance so far. And so really, what we wanted to do was just start to reduce risk. So the idea was, again, you don’t know if there’s going to be a second way, you don’t know how the election is going to go. You don’t even know how the market is going to react to the results of the election.
Again, point in 2016, there was pretty big consensus out there that if Trump won, the market would crash and things would be thrown in disarray. So even if you had known the results of the election, which most people didn’t know, you wouldn’t necessarily know the market direction.
So the advice that we really been taking was just reduce risk into this known unknown scenario. So whether that’s reducing some of your higher beta plays within small caps, mid caps, emerging markets, and potentially taking a little bit off, off the table in terms of that growth tilt, go a little bit more towards blend, a little bit more towards value.
So from a sector basis, don’t be so heavily concentrated within technology, communication services, and those parts of the market that have worked as well as they have. Put a little bit more to that value trade into that cyclical trade in terms of financials, industrials, materials, et cetera. So it’s a two pronged approach reducing beta in terms of various asset classes, and then from a sector basis, by traditional metrics are actually dialing up your risk because of cyclicals in theory, it could be even more volatile, depending on the results of the election.
But in this case, based where risk reward stands and where you’re looking at the pricing of all those sectors, we’ve gotten to a point where just like technology is considered to be the safe trade for this year, which is counterintuitive than prior cycles, it’s very possible some of these very inexpensive industrials and financials, again, within high quality companies that have the balance sheet to withstand a potential more economic trouble for the next let’s call it six to 12 months.
The way that those companies are priced, present actually a little bit more safety. So that’s really what we’ve been advising both our clients and our underlying advisors to the extent that they’re managing portfolios as well. Just reduce a little bit of risk, be ready into the election to take advantage of it whichever way it goes.
Because we do think we are going to see a really big shift in terms of, we’re going to see that catalyst through the election. And one point we haven’t touched on is, it’s not just important who wins the presidency, but also, which party takes control of the Senate. So I think that will…
AT: Of course, yeah.
SA: And speaking of that, I wanted to talk about the stimulus for a second. Aaron, I’m struck going back several months on this show, both the hosts and guests have been kind of well, of course, there’s going to be another stimulus package, people are hurting.
There’s a president — not just a presidential election, but 535 house elections, and a third of the Senate is up for election. Of course, there’s got to be something for the election. Here we are before the election, and we’ve got nothing. Now the conventional wisdom is, of course, there’s going to be a stimulus, whether it be in the lame duck session, or early in 2021, regardless of who wins the White House.
And I’m wondering, if there’s the possibility that, maybe we’re all getting, maybe there’s no stimulus? And is that a risk to the marketer, or can the market kind of sail right through that?
CZ: That’s definitely a huge risk to the market. If there is not a stimulus package on the horizon for any time to come, that’s a huge risk to the market, because clearly, the economy is recovering. And we’re going to probably see some pretty amazing GDP numbers out on Thursday in terms of Q3 bouncing back.
But again, we had the similarly shocking and historic numbers in Q2 in terms of the drop. So just the fact of the monumental drop in Q2 GDP, we’re likely to see a really positive GDP print on Thursday. And so, be that as it may, that’s just the bounce back from absolute devastation to the economy, to the economy slowly getting back on its feet.
But I think most people would agree that, in order for GDP and the economy to go back to let’s say, 2019 levels or even 2016 levels, pick your point in time prior to the COVID crisis, whether that’s the accelerating economy that we saw prior to the crisis or whether even just the slow recovery that we saw post financial crisis from 2008 to call it 2016.
For the economy to go back to what we would consider normal in non-COVID times, still going to require time. And so, the bridge to where we are right now, which is an extremely weak economy with various stages of reopening to what we would consider more normal, you’re going to have to have a fiscal package.
And the market is absolutely betting on a stimulus coming at some point, whether it comes before the election, which is something we were skeptical of, or during the lame duck period, which is going to be completely dependent on how the election goes. There is pretty good consensus that, in 2021, we’re going to see some spending.
A scenario where the CMOS might fall apart would be a split Congress, where you’ve got the democrats retaining control of the House, the Senate remaining in republican hands, and potentially a Biden president, which the Republican Senate will want to push even more against, that’s probably the worst scenario in terms of the likelihood of stimulus.
Whereas if you run the table, and you look at a democratic house, Senate and Biden winning the presidency, that’s the scenario, which is most likely to see stimulus just based on what you’ve seen politicians say, and due to date. So, that’s really where things lie. But you’re right, I think there’s pretty strong consensus that under almost any scenario, you’ll see stimulus next year. And it’s possible that that’s not true.
AT: Yeah, I’ve come to the point where, things that seems so obvious from the rational point of view. It almost seems like Congress, and this is bipartisan, they’ll do the opposite, right? That just happened with the debt ceiling a few years ago, remember like, of course, we’re going to raise the debt ceiling, and then we didn’t and we got downgraded.
And, that was a minor fiasco for the markets for a couple days at least. And the stimulus again, any politician, you would think would be good to help your constituents, given this extraordinary circumstance we’re in. And that would be good for both parties, and certainly anybody who’s running for election, but that’s maybe that’s why I’m not a politician, because that makes too much sense in a rational world.
And that’s, I’ll get off my soapbox now. Sorry. Because and I should say, we tend, we try not to talk about politics, this isn’t a political show. I will note, you also commented that the market has moved from the narrative that Trump is better for the markets through less regulation and taxation to the narrative that a Biden win, if certainly, if there’s a democratic sweep in Congress will lead to additional economic stimulus for the economy.
And this is very anecdotal. But I was talking to a friend of mine the other day, he was saying, Well, if Biden wins, I might think about selling some of my stocks because capital gains taxes are going to go up. Are you hearing any kind of that sentiment out there? Do you think that that is a risk for the markets here if there is a Biden win?
CZ: So, I think when you look at the capital gains taxes going higher, as well as individual taxes going higher, there’s been that discussion and I think you’re right within the retail community, assuming you’re looking at the dollars they have in a non-retirement account, which is something that they would actually be concerned about taxes as opposed to their IRA or 401 K’s or other retirement accounts, which are tax free until you distribute.
I think there will be some of that in December. So assuming Biden wins, and potentially with a democratic sweep, you’ll have that temptation to try to take some profits heading into the New Year. We’ve really been trying to caution people against it. Because what’s the point in realizing taxes right now in any event if you need the money in 2021? Yes, it makes more sense to sell in December, rather than selling in April and May.
But if you think about that amount of money that’s in the stock market that was going to come out anyway in the short term, that’s really pretty de minimis when it comes to the overall stock market. And if you take even a further step back, and you look at all of the different institutions and money that’s in the stock market, there’s a vast amount of money in the stock market, whether it’s sovereign wealth funds, whether it’s pension plans, endowments, there’s a lot of money in the stock market that is unaffected by the capital gains rate.
So you are going to hear a lot of anecdotal stories of retail and individual investors who are going to be thinking about selling, and some of them will. But I’d be surprised if that was enough to really move the market. And frankly, even for those people who would be tempted to do it, hopefully, they have a lot of financial advisors that are telling them well.
If you’re not going to need that money for five years, 10 years, 20 years, why would you realize taxes right now, even if it’s at 20%, as opposed to 40%? Especially, because what are you going to do with that money? Are you just going to realize some gains now and then go back and reinvest in the market? Where else are you going to put your money?
So I do think there’s a less of that story than meets the eye. Even though I agree, I hear more and more about it. And we do have that question from clients quite a bit.
SA: And I think that’s really good advice. And isn’t necessarily a political preference, but I think, kind of a blue wave, the idea that we’re going to get a really big fiscal stimulus package far outweighs whether capital gains taxes go up a little bit, and you probably want to be a buyer on a blue wave, because the fiscal stimulus is going to be way bigger than its price then.
CZ: I think that’s right. I think that’s right.
AT: Right. And as long as we’re on this topic, but they’re also and again, I’m just playing devil’s advocate here. There’s also the likelihood in Biden’s campaign on this that, that corporate tax rates will go up. And in Biden administration, itself there is a blue wave, quote, unquote, corporate taxes will go up significantly, maybe to back to where they were.
And you could argue they weren’t high enough, then but that’s a different discussion. Again is that — do you think that’s being priced into the market here? Or how do you think that that will be set — how do you think the market would react to something like that?
CZ: I think that is being priced into the market. And I think the dynamic is exactly what we were just talking about. On the downside for the market is the fact that corporate tax rates would almost definitely go higher at some point, even if it was delayed by a year because the democrats were waiting for the economy to recover a little bit.
So they have a lot of spending priorities that they feel like they need to pay for. And something they will definitely go after and something they said they would go after is the corporate tax rate. So, on the downside for the stock market, clearly earnings — net earnings after taxes are going to go down. On the other hand, it’s really the stimulus.
It’s the actual underlying economy in the short run that I think the market is moving on. So if you look at baskets of stocks for those companies that have most benefited from the Trump tax cuts back in 2016, those companies have underperformed other baskets of stocks where companies are less affected by a tax rate increase for whatever reason, whether they have multinational operations, or whether they were more tax efficient to begin with.
So to that extent, I think you are seeing that price into the market. But again, if you move from let’s say, an effective tax rate of 21%, up to an effective tax rate of or an effective tax rate of 20%, let’s say up to an effective tax rate of 28%. If you think about it, you’re retaining 72% of your earnings as opposed to retaining 80% of your earnings.
So effectively, 10% less of your earnings are being retained in a tax environment where corporate taxes just go back to where they were prior to the Trump tax cuts. That 10% drop in net earnings is a lot smaller than the amount of stimulus that would be heading into this system for next year, which is why I think at least in the short run, you’re going to see the tax effect outweighed by what’s happening with stimulus.
And that’s why so much of the market is focused on stimulus. But again, when you’re in a scenario where the tax rates at 20% versus the tax rates at 20%, it’s always about what’s your alternative? So all things being equal, if the stock market was surely focus on that one factor, the stock market should be down by 10% in that environment.
But because there’s so many more factors at play, and you again come back to the scenario where else you invest, I think it’s really going to be a sorting out of which companies within the stock market are most impacted by that change. And you may see some reallocation of money. But that doesn’t necessarily mean that the overall value of the stock market needs to drop by 10%. Because that’s really not how markets work.
SA: Right and clearly — and the market was doing pretty well prior to Trump’s election and the change in the corporate tax code too. So, there’s this idea that unless there’s a unless we go back to 90 plus percent marginal tax rates at the high or European style corporate tax rates, it’s probably not going to make a huge difference to most companies or most investors over the long term.
So, this is a great segue to talk about earnings. So you mentioned corporate earnings and obviously, this week, a huge week for corporate earnings 170 companies in the S&P 500 are reporting. According to FactSet and this is a quote, at this point in time, the percentage of S&P 500 companies beating earnings estimates for the third quarter, and the magnitude of the earnings beats are at or near record levels.
Obviously, a lot of negativity was priced in these earnings. And corporations are beating those numbers. You had an interesting comment. And again, I’m quoting here, now is the time to begin investing in those companies and industries that will eventually revert to the mean in terms of earnings and quote.
Now, I think you alluded to this earlier, but can you talk about what you mean precisely by those words, what kind of companies are you talking about you think are going to revert to the mean?
CZ: So exactly, I think those companies within industrials, within financials potentially within materials, a lot of those cyclical companies which have really been disproportionately punished by the COVID lockdowns and stagger re-openings, those earnings on a cyclical basis have really been devastated.
And so, to the extent that the market will always go through any recession, whether it’s a typical recession or whether it’s an unusual unlike this one, typically you’ll see PE ratios expand as investors don’t just maintain the same PE ratio for stocks earnings going down, when they expect at some point in the future, they’ll go back up.
But there has to be some type of balancing act between the fact that their earnings are at depressed levels, but will bounce back at some point. Our thought is that, given that we’re going through this cycle again, albeit for different reasons than normal, you will see an eventual recovery, especially within those cyclical companies, which can withstand more pain.
If it’s going to be another six months, or it’s going to be another 12 months before the economy truly gets back to normal, whether that’s through a vaccine, whether that’s through herd immunity, whether it’s through eventually people — consumers moving through this particular scenario. And I think that’s a pretty generous timeline.
12 months is much longer than I think almost anyone you’re going to talk to you in terms of saying, when are we going to be through this crisis? And again, it could turn out that we’re all wrong, and it lasts even longer?
CZ: But to the extent that companies, whether that’s the airlines, whether that’s particular banks, whether that’s chemical companies, even to some extent, if you’re in the right type of real estate investment trust, I think you’re going to see a lot of those earnings eventually get back to where they were prior to the crisis. I think it’s not that far abridge to say that, as conditions normalize, consumers go back to normal behaviors, you can at least see a lot of recovery in terms of earnings.
And therefore, it’s not unrealistic to expect at some point, all of those companies that are trading at really, really depressed prices. Eventually, at least get back to where they were prior to the crisis. That’s the reversion of the mean, both in terms of earnings per share, as well as actual prices for each of those companies.
And so, right now, I think when it’s when it’s darkest and most daunting is when you want to at least be a little bit contrarian, and start stepping into that trade even now.
AT: So you didn’t mention them specifically. But I have to ask you, it doesn’t get much darker right now than energy stocks. Are they on your radar, as a reversion to mean type play that you just described?
CZ: Not yet. And I think what’s really been challenging about this entire investment landscape is we really did see it and this has been said before, but I happen to agree with it. A lot of the trends that you saw coming into 2020 from 2018 and 2019, have really accelerated during the crisis. We really saw both going and consuming in person to ordering online, that trend was already in place prior to the crisis. It feels like this COVID pandemic has accelerated that crisis.
The move of companies to the cloud, digitization, moving more towards artificial intelligence and then looking on the energy side, that idea going towards more energy efficiency, going more towards electric vehicles, there’s been a general trend in trying to reduce energy exposure. And clearly, that was also accelerated as well.
So I think for those types of investments that were already a secular decline prior to the crisis, you have to be very careful to expect those to ever bounce back to anything where they were meaningfully before the crisis. Now, clearly anything that’s been disproportionately punished because of lockdowns, they’ll recover that extra portion of whatever earnings they’re missing when things go back to normal.
But for those companies that were already in secular decline, regardless of the pandemic, they’re much less likely to revert to the mean, unless you consider the mean to be constantly declining in which they would, they would.
SA: But I like that the mean is constantly declining. That’s a great concept. So I know you can’t talk about individual stocks. So how would you recommend someone who, let’s say I’m listening to this podcast and you’ve convinced me, Okay, I want to take a look at these the reversion to mean in the — where they’re not cyclically declining, industrials, financials, how would you recommend someone invest in that from here?
CZ: So, it really depends on the type of person that’s listening to the podcast. Of course, there’s a lot of active managers, so you can look for those value investors and try to look away from active management on the value side move away from active management on the growth side, at least reallocate your portfolio.
I would not be surprised to see that most investors, most people, whether they’re retail, institutional or otherwise, are heavily concentrated towards growth stocks in the technology sectors, in communication services sectors, potentially, even within semiconductors. And so, just reducing some of that overweight, I’m not saying that that trend will revert to mean. And those companies that have done well to the crisis are likely to do well coming out of the crisis, however, a lot of that is priced in.
So, one of the ways is just reducing some of that exposure in those areas, take that money and reallocate it towards more value investments, or more towards those types of sector plays. So without recommending, again individual products, there’s a number of sector ETFs that can be used. There’s a number of value investment ETFs that can be used and there’s a number of value managers.
If you’re one of those people who wants to buy individual equities, you’re going to have to go and find whatever screening tool you like best, whether that’s something free, or there’s something that you pay for, and you can look within those sectors. And again, look at earnings in 2016, ’17, ’18, or ’17, ’18 and ’19, have a look at which of those companies you think would have done well in 2020 before the COVID crisis happened?
And then the last step I would say, is just a safety check. You’ll look at those debt-to-equity ratios, look at your debt-to-EBIT, make sure that whatever individual companies you’re going to buy, in addition to having a good trend prior to the crisis are also financially strong. Because there’s a lot of value traps out there.
You really would not want to bet on a quick reversion to the mean, because it’s possible that reversion to the mean does take six to 12 months. And we’re not market timing by any means expecting a vaccine by the end of the year, or some type of radical change in the market. We’re just merely pointing out that, now is a good time based on valuation to at least begin exploring some of those other options.
And from our point of view, we have slightly rebalancing our portfolio accordingly. And we think, and that’s contrarian in a way that’s much more safely than a wholesale revamp of your entire portfolio.
SA: Now Chris, we haven’t talked at all about fixed income, the 10 year Treasury yield, of course, is microscopic 0.8%, corporate spreads perhaps narrower than they otherwise might be. Thanks to one intervention from the central bank. Do you have any areas of fixed income that look interesting to you?
CZ: I think you can do the similar type of analysis within fixed income as what we were talking about within equities. And again, that’s looking for those parts of the market that still show some value. It’s a lot more difficult in fixed income. Fixed income is really benefit from broad buying by the Federal Reserve.
So to the extent that, I was alluding to some of the equity sectors as being overvalued, you can see large swaths of the fixed income markets that look very expensive. So, a lot of the high yield market is probably inordinately tight in terms of spreads to treasuries, and likewise within in corporate bonds. So I think you have to be a lot more selective within fixed income.
Again, I would push probably more for active managers within fixed income, but if you were looking at broad sectors, I do think there is some opportunity in some of those fallen angels, let’s say, those companies that should be investment grade but because of the of the pandemic maybe have just dropped below investment grade.
And we will be looking a little bit from a cyclical basis. I think a lot of the sectors that are difficult to invest in on the equity side, such as energy, maybe also difficult to invest on the corporate bond side. Likewise, if you could look at some of those industrials, financials, materials that have that financial strength, and potentially are trading with a little bit wider spreads than the overall index, those may be some interesting areas.
But I think if you look at treasuries, or if you look at mortgage backed securities, treasuries look really expensive. And it is difficult to have the risk reward there, in terms of the yield curve really steepening and you getting hurt from a rates perspective. And likewise, I think if you look at asset backed securities, whether it’s mortgage backed securities or other types of securities like that, I think, a lot of those have held up so well that they’re almost priced for perfection.
So I think you have to be pretty selective.
AT: So Steve, I’m really glad you asked about fixed income. And Chris, that was a great answer. And I’m going to ask you a question that I suspect, could probably we could probably spend a couple of hours talking about and we are running, and I appreciate your time.
So probably shouldn’t be asking this at the end of the podcast, but I’m going to ask it anyway. What do you say to this idea that I’ve been hearing more people talking about that, given where rates are and the likelihood that they’re going to remain low for a long time, that the traditional 60:40 portfolio is no longer relevant, and investors should really start rethinking that whole paradigm?
CZ: You know, I hear that a lot. And that’s definitely spoken about a lot more from an institutional setting. There’s not a lot of retail investors that come up to you and ask you about that. But they hint at it, they do ask, why should we have bonds in our portfolio if they pay so little? Why shouldn’t we be looking at things that are not correlated to the to the stock market, whether that’s alternatives or something else like that?
And so, we’re pretty traditionalist. It’s not to say that we would never look at alternatives. And I think, there are alternative investments out there that can act as good diversifiers for both traditional fixed income and traditional equities. But in general, I do think that, for that investor that needs to have a certain allocation to equities, I would necessarily change my allocation to equities, and take more risks just because fixed income looks like it’s less attractive in the long run.
Really, your risk tolerance should dictate what your percentage is allocated to equities with your portfolio. And then the question becomes, what do you do with the other part of your portfolio that’s not in equities? And so, we still believe that a good balanced fixed income portfolio, including allocation to treasuries will provide some carry and some current income over the next three to five years.
Even though rates are low from a relative basis or relative value point of view, rates can still go lower clearly, and that’s likely to happen in periods of stress. So when your equity portfolio needs it the most, it is possible that bonds will rally. And so, I think, we’re not ready to throw out the traditional 60:40 yet.
However, what we would say is that don’t forget about cash, even if you move away from alternatives, looking at equities and fixed income to the extent that cash can be used to a greater percentage within your fixed income allocation, that in and of itself is almost a third category. I know you can use t bills and there’s other fixed income instruments you can use.
But traditional fixed income which maybe doesn’t have as good a risk reward profile going forward, just cash as a way to provide some of that stability of principle when your equities need it most is something that people should be not forgetting about.
AT: All right, Chris, thanks very much. It’s been great having you on today.
CZ: Yeah, really good talking to you as well.
SA: Thank you, Chris.
AT: Our guest has been Chris Zaccarelli, Chief Investment Officer of the Independent Advisor Alliance. You’ve been listening to Alpha Trader.
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