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1 March 2020
Dear Investors & Traders
Global Markets Correct Sharply
In the last 7 days, the S&P 500 went through its fastest 16% drop in history. I was in awe of this ‘once in a lifetime’ black swan event. A 10%-20% drop in the S&P 500 is common but it usual happens over a period of several weeks with a series of impulsive and corrective waves. (SPY).
In this particular instant, prices dropped in one straight line down. For most people, there was very little reaction time to hedge their portfolios. I just happened to be lucky to put on some Put Options on 21st Feb before the big plunge and generated some profits on the way down. In this instance, I just got a lucky hunch and it had nothing to do with some special indicator I was using (many students asked me how I knew). Never-the-less, I still saw my portfolio value drop by 10%.
The plunge in prices was so fast and widespread that some stocks are now selling at irrationally low prices, especially stocks that have fundamentally nothing to do with the Covid-19 catalyst. For example, health care stocks like Johnson & Johnson (JNJ), Military Defense stocks like Lockheed Martin (LMT) and Consumer staple stocks like Nestle (NSRGY) should logically not be affected by the epidemic or an economic slowdown. Yet, their prices fell as well.
Algo Trading, ETFs and Margin Calls Accelerate the Fall in Stock Prices
What is causing this faster and more widespread drop in stock prices? Why are some stocks falling even if their underlying fundamentals (i.e. Sales, Earnings) are not likely to change much?
It is mainly due to a combination of algorithmic (robot-machine) trading, the proliferation of ETFs and increasingly more leveraged investment accounts being hit by margin calls.
Currently, 80% of trades done on the stock exchange are done by robots (machines) where buying and selling is NOT based on the fundamentals of companies but purely based on mathematical algorithms that trade on price action. Millions of computers with trading software are programmed to sell stocks once certain price levels are hit. As prices go down, it triggers the stop losses and short sell trade orders in these computer programs, which in turn creates more selling. This domino effect is what contributes to the free fall in prices to irrationally low levels that can be disconnected from the company’s actual fundamental value.
Increasingly, more and more investors are buying ETFs instead of individual stocks. When investors buy the S&P 500 ETF (SPY) for example, the ETF has to actually buy the shares of the 500 companies that make up the ETF. Conversely when investors sell shares of the SPY, the ETF will sell the underlying shares of the 500 companies. This causes increasing correlation between stocks in the market.
When the market starts falling, it will trigger investors (including 80% of those robots) to sell the ETFs in their portfolio. Guess what happens, this will cause the selling of all 500 of the stocks in the index, even the stocks that may have nothing to do with the reason for selling in the first place. Once again, this why a health care stock like JNJ can fall 10% even when it should logically rise in a health epidemic situation. JNJ falls because it got sold together with all the other 499 stocks in the ETF. The baby is thrown out with the bathwater.
Finally, because of low interest rates, more and more investors are borrowing money to invest. This is known as margin financing. For every $100,000 in cash, they may buy up to $200,000 to $300,000 in stock. While leveraging can magnify their returns as prices go up, it can also decimate their portfolio if prices were to fall too much.
When prices fall too fast, these investors will get hit by margin calls. This means that they have to quickly pay up for the huge losses from the money they borrowed or risk getting their stocks forced sold by the broker. Many of these people cannot meet their margin calls and the broker forces the selling of the stock and this in turns creates more selling and the freefall in stock prices.
So, it is the combination of robot trading, ETFs and forced selling of leveraged accounts that causes the irrational changes in stock prices within a short period of time. Johnson & Johnson (JNJ), which was priced at $154 per share is now priced at $131 (15% lower) 1 week later. Amazon (AMZN), priced at $2185 a week earlier, is now priced at $1,800 (18% lower).
Is Volatility Your Friend or Foe?
To ignorant, untrained retail investors, this can be extremely un-nerving and confusing. Seeing the value of their wealth fall by 10%-15% in a week will make their stomach churn, cause panic and sell in fear (usually at the worst time). The typical retail investor hates this kind of volatility and blames it on the market being manipulated (which is true to a certain extent). This is why ‘conservative investors’ rather place their money in ‘safer’ investments like ‘fixed/time deposits’ so they can feel more certainty. In the long run, these ‘conservative’ investors see their wealth destroyed by inflation and lower interest rates.
By contrast, experienced and professional investors (hopefully many of you), LOVE volatility. Volatility is our best friend. Volatility is what causes the temporary MISPRICING of stock prices and it can make us very rich when we have the confidence to buy at undervalued prices when others are fearfully selling. To do this, we need to disassociate emotionally and to think logically.
As a trained investor, we are 100% confident in the intrinsic value of the underlying business. We know that Amazon is really worth $2,500 per share. We know that 3M (MMM) is really worth $185 and Microsoft (MSFT) is really worth $180. The actual value of the business has not changed in a week.
People are still ordering online from Amazon (maybe even more so now), people are still using Microsoft software and cloud services and people are still buying Johnson and Johnson medical devices and drugs (maybe even more so). The businesses are still generating the same sales, profits and cash flow as they did a week ago.
When I am 100% confident that the value of the business (and the share price) will rise in the future, it does not bother me if the temporary mispricing of the market shows the stock price being quoted at 10%, 20% or even 50% lower. All it does is give the opportunity to acquire somebody else’s shares at a bigger discount. Their fear and impatience results in my eventual profit.
For example, I am confident that Amazon will be worth $2,500, $3,000, $5,000 per share in the future. Since I am a buyer of AMZN shares, the lower it goes in the short term, the happier I will be. This difference in mindset is what separates the typical fearful investor (who loses money over time) to the professional cool investor (who makes money over time).
Just 5 years ago, AMZN fell from $697 to $469 per share in Feb 2016. A 30% decline because of whatever problems were happening at the time.
AMZN Feb 2016
If you had believed in the fundamentals of AMZN and held on instead of selling in fear, your $469 would be worth $1,800 per share today (almost 3-fold increase in 4 years).
AMZN Feb 2020
Remember that the stock market is one big roller coaster. The only people who get hurt are those that jump off the ride halfway through. As long as you stay on the ride you will always make it to the destination.
Of course, this assumes that you get onto a fundamentally good roller coaster that you know will reach the destination. If you pick a poorly maintained coaster (lousy business, weak economic moat, inconsistent earnings), it could derail, crash and never reach the destination. This is why the most important thing is to only include the fundamentally strongest businesses (with wide economic moats) in your portfolio or Index ETFs. You can subscribe to the Ultimate Investors Playbook™ to watch my personal investment portfolios live.
Even though stocks like Tesla (TSLA) and Beyond Meat (BYND) may seem exciting in the short term and could be very profitable for short term trading, it is something that I would NOT dare include in my investment portfolio. These are the kind of stocks do not have a track record of predictable earnings and cash flow.
Technical Analysis of the S&P 500
After falling for 7 straight days (-16%), the SPX is ended the week with a bullish candle at the 2,890 support level. It broke 200MA (red line) which is the strongest MA. However, this is not yet a bear market signal.
A bear market is signalled when
a) 50MA (blue) crosses below 150MA (green) with both MA flattening or sloping down OR
b) Price crossing below 200MA with 200MA sloping down OR
c) Price falling more than 20% from the high.
For now, we are still in a correction within the uptrend that is structurally still intact. Healthy corrections are inevitable as part of an uptrend
SPX Daily Candle Timeframe
SPX Weekly Candle Time Frame
Relief Rally Bounce Expected
I expect the SPX is bounce up next week because it is deeply oversold right now. On daily timeframe, Stochastics and Bollinger bands show oversold levels and SPX closed the week with a bullish candle on a previous support level. On the weekly timeframe, the SPX also bounced off the 100MA (yellow).
The S&P Short Range Oscillator (I pay $500 a year to subscribe for this special indicator) is also showing -12.73% which is extremely oversold. It’s like the pendulum has been swung to the extreme left and it going to snap back to the other direction.
You can see that when the Oscillator hit these extreme negative levels in the past (-10% in Jan 2018 and -12% in. Dec 2018), it bounced back up very strongly. This is why it’s not safe to short the market or smart to sell stocks after a panic plunge.. it tends to precede a strong bounce.
Of course, this is not 100% and anything can happen in the markets. Now that the US has just reported its first Covid 19 death, it may create even more selling on Monday before a bounce.
My Game Plan-
Buy My Favourite Stocks But Prepare for Possibly Lower Prices
After the much anticipated bounce from oversold levels, the SPX could go back to make new highs OR it could hit a level of resistance and continue going down even lower. No one can predict if the correction will end here, last longer or even morph into a bear market.
The good news is that to succeed as an investor, we do NOT need to predict the future with certainty. We just need to focus on the fundamentals of the underlying business behind the stocks in our portfolio.
As long as we include wide moat, highly profitable stocks and buy them at reasonably good discounts we will do just fine. At the same time, we should also do the following to reduce the volatility and improve the performance of our portfolio.
1) DIVERSIFICATION. Ensure your portfolio has a good diversification between growth stocks, defensive stocks and cyclical stocks. Also ensure a good diversification between different markets (i.e. US and China).
This is the current allocation of my investment portfolio. A good amount of defensive stocks (24%) and secular technology growth stocks (23%) will ensure a buffer in case this covid-19 slows the economy down and tips it into a recession.
2) DOLLAR COST AVERAGE . Last week, many of my core stocks fell to undervalued levels and once they hit a strong level of support, I started adding more shares. An example would be JNJ where I added at $132 when it hit the 200MA support on weekly candles.
Another example is adding BAC at $28+ when it hit 150MA support on weekly candles. You can subscribe to the ‘Ultimate Investors Playbook™ to get real time alerts when I make a purchase.
I am also taking the opportunity to add more shares in Singapore listed REITs (Real estate investment trusts) as they became very attractive again, selling at dividend yields of 5% to 8%. For example, Capitamall Trust (that owns the major Retail Malls in Singapore) is now offering a 5% yield and its price has retraced to a strong support level at $2.27.
Although these stocks are fundamentally undervalued and hitting strong support levels, I always acknowledged that it is no guarantee that it is the bottom. Support levels can be broken and if we go into a bear market (which I still think is not likely), prices can be quoted even lower still.
This is why I always buy in many stages. So if I wanted to buy an additional 100 shares for example, I would buy 25 first, then another 25 at the next support level or retracement etc.. This way, I will get a good average price in the end. When the market eventually comes back to its senses and prices the stocks properly, I will make a lot of money.
3) HEDGING (Optional) . More experienced investors and traders can also consider hedging your portfolio by shorting the SPY, buying the inverse ETFs (SH, DOG) or using Options (i.e. Put Option Spreads).
While I know the market will always go up eventually, I always like to generate short term profits while prices are going down. To me, the ideal time to go short (using Put Option Spreads is my favourite instrument) is when the SPX breaks a support level OR rallies and hits a resistance level.
Looking back at the chart below, you can see that once the SPX bounces back up (black line) to a level of resistance (i.e. moving average or Fibonacci level) I would start to employ more Put Option Spreads just in case we have a scenario where the market plunges back down again (red line). My Put Options will then generate short term trading profits that will give me more cash to buy my favourite stocks at lower prices.
Before employing hedging strategies I highly recommend investors fully educate themselves by learning trading techniques and option strategies. The Professional Stock Trading Courses and Options Trading Courses cover this extensively.
While investors can use Inverse ETFs or short sell the underlying ETF or stock, I prefer to use options as an instrument. Options havce an inherent leverage that allows me to protect (hedge) an entire portfolio by paying a premium of just 1%-2% of the portfolio size. This is just like buying a term insurance policy. small premium but big payoff if we die (or critical illness).
In other words, to protect $10,000 worth of stock value, I just need to pay a premium of $100-$200 for a month of protection. However, if you hedge using gold, bonds, inverse ETFs, you need a sizable allocation in order to hedge the downside in your stock allocation.
Using certain option strategies like Put Option spreads, I am also able to get a risk to return ratio of 1: 2, 3 or more. However, If I were to use an Inverse ETF, My risk/return ratio is only 1:1. If the stock market goes down, the inverse ETF makes a $1 but if the stock market goes up, my inverse ETF loses $1 as well.
Statistics of Corrections and Bear Markets
So far, the SPX is only in a correction mode and the medium-long term uptrend is still intact. So, how often do these corrections last?
Since World War II, there have been 26 market corrections with an average decline of 13.7% (correction defined as a drop of 10% of more). On average it takes the market 4 months to recover back to its previous high.
If the correction turns into a bear market, then recovery back to all-time highs would take slightly longer.
There have been 13 bear markets since World War II with an average decline of 32.5%. Bear markets have lasted 14.5 months on average and have taken two years to recover on average. The last bear market was actually in December 2018 when it lasted only 2 months and declined 20%.
At this stage, a bear market is not in the cards but as an investors it is always important to prepare for any eventuality and to expect that anything can happen. I am still holding and adding shares to companies I believe will rise in value over time and at the same time, using options as a tool to generate profits during any short term downward price movements.
China Market is Resilient As Covid 19 Slowdown
The interesting thing is that while the US and the rest of the world has been plummeting, the Shanghai Composite index has been remarkably resilient. This could be because of the fact that new cases have been reported at a slowing pace and businesses are beginning to return to normal.
ASHR ETF (that tracks the Shanghai Index) ,m my. Main china ETF holdings has been consolidating during the plunge in global markets.
ASHR ETF (Weekly Candles)
After closing 85% of its stores, Starbucks has started to open for business again. Apple’s factories are also beginning to re-open as well.
This is the good thing about having my portfolio diversified between the US and China. When China was falling few months ago, the US was going up and now the two markets are reversed.
On a Side-note….
As you know I also day trade forex and swing trade stocks to generate additional returns that are independent of the stock market. Interestingly enough, while the stock market had the fastest decline in history, my forex trading account had one of the longest winning streaks.. I got 9 winning trades in a row in a day (20th Feb)! Just a coincidence I guess.
After bragging to my community of forex traders, one of my students promptly pointed out that he just hit 12 winning trades in a row. Well, happy when students can outperform me
Upcoming Live Courses (www.wealthacademyglobal.com)
• Wealth Academy Singapore 19-22 March 2020
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Online Classes at www.piranhaprofits.com
• Value Momentum Investing™ Course
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• Professional Forex Trading Course (level 1 and 2)
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Stay safe and may the markets be with you
Adam Khoo
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