What follows is a compilation of some of my articles from my Daily Diary on Real Money Pro over the last month combined with a recent letter to my investors at Seabreeze. It outlines my ursine market views and attempts to deliver my honest and transparent review of how I have tactically handled a much more robust stock market than I expected since April 2023.
During the last several months I have adopted a negative market outlook and established a net short exposure. I based my negative market assessment on what I believed to have been thoughtful and objective fundamental analysis coupled with a disciplined evaluation of upside reward vs. downside risk and an eye towards "margin of safety."
Despite my lengthy analysis and bearish protestations which have been embraced and shared by some of my more thoughtful friends and investment icons -- like Warren Buffett, Lee Cooperman and Stan Druckenmiller -- stocks have moved steadily and merrily higher over the last three months, much like they did two years ago, which led to an important market top at year-end 2021.
In adopting a net short exposure at my hedge fund early in the second quarter of 2023 I missed opportunity as our hedges became a hedge against profits. But, as we will briefly discuss here, we did not lose capital.
As an investor managing other peoples' money I employ an absolute return strategy ("for all seasons") and would naturally prefer to be more correct in view than wrong. Importantly, though I grew progressively more bearish and net short over the last several months, in the aggregate we did not lose capital during the market's spirited multi-month advance as our overall risk control and management of our net short book was good and proved effective. Indeed, as noted below, the net asset value of our hedge fund, as of Friday's close, though underperforming the averages, is at a 2023 high.
Managing a Partnership comes with periods in time when the strategy is out of favor and wrong-footed -- it is part of the investment process. While we seek to limit those experiences, it is equally essential to moderate losses when the market does not conform to expectations.
At my hedge fund, Seabreeze, we are merchants of reality and not purveyors of doom. Ours is not a permanent (bear) position as we recognize that, over time, stocks rise and being long stocks generates wealth. But there are periods of time that being short stocks preserves wealth. Seabreeze's profitable returns in 2022 were a good example of the benefit of employing a bonafide long/short strategy.
Today many hedge fund managers are fleeing from shorting individual stocks. The quote below by Dan Loeb is symptomatic of this trend:
"Fundamental analysis is increasingly taking a back seat to monitoring daily option expiries and Reddit message boards, as evidenced by the numerous short squeezes and manipulations of heavily shorted stocks such as AMC and Gamestop in 2021 and others this year... While we have not abandoned short selling, we continue to reduce our single name short exposure in favor of market hedges and short baskets."
-- Dan Loeb, Third Point Hedge Fund
Philosophically what differentiates our hedge fund from many other hedge funds is our lengthy shorting experience that has resulted in solid short-selling profits over history. (I have a three-hour lecture on short-selling in the annual curriculum of Dr. Shiller's class I teach in at The Yale Graduate School of Business!) We are convinced the departure of many hedge funds from short-selling has created an even wider opportunity for Seabreeze Partners to capitalize in the growing unpopularity of shorting individual equities -- regardless of market direction.
As always, we try to judge equities objectively and dispassionately -- assessing upside/downside risk in the broader markets, in industry sectors and in individual company shares. FOMO (fear of missing out) and animal spirits, emotional factors so conspicuous recently, are typically fleeting catalysts especially when they are ungrounded by solid fundamentals or based on errant economic and corporate profit assumptions.
History suggests that risk can happen fast. As a general rule, markets take the stairs up and the elevator down. Historical precedence has demonstrated that the steeper and smoother the staircase, the swifter the elevator.
Just as we felt back in late 2021, today, equities appear vulnerable to a number of fundamental, policy, positioning, sentiment and valuation threats which we will discuss further (below) in this column.
Importantly, like Bertrand Russell, we are fact-based investors who avoid emotion in the management of other people's money.
"Never let yourself be diverted either by what you wish to believe, or by what you think would have beneficent social effects if it were believed. But look only, and solely, at what are the facts."
Perhaps of the greatest factor in our market outlook is that it is likely that interest rates will stay "higher for longer" and that liquidity will decline as the Fed stays "tighter for longer."
The level of interest rates bears heavily on valuations -- as the risk free rate of return is one of the foundations of discounted dividend models, used for valuation purposes. As I wrote yesterday:
Accumulating Interest Rate/Stock Market Valuation Headwinds
* The real rate of ten year Treasury note (over 1.80%) is up to 2009 levels:
Source: Bramo Tweet (Bloomberg)
* The Equity Risk Premium is paper thin from an historical standpoint.
* The one year Treasury note yields 5.41% against the S&P dividend yield of only 1.51% - the largest gap in almost two decades.
* As witnessed by this morning's stronger than expected retail sales print, the domestic economy has grown less rate sensitive than in the past. This is especially true in the residential real estate market where existing homeowners can't afford to move and "trade up" due to the massive refinancing to low mortgage rates during the Fed's decade long plus zero interest rate policy.
Domestic economic growth is slowing even as the probability that the rate of inflation may accelerate of the next 12 months is rising.
Europe is falling into a recession and China -- the engine of global growth -- is foundering
The annual U.S. deficit and our country's debt load is growing unchecked by either political party (and has led to Fitch's downgrade of U.S. debt). Rising debt and higher interest rates place pressure on debt service costs and will restrict U.S. economic growth:
Geopolitical risks are rising while international economic cooperation is eroding.
Investors have grown more optimistic as reflected in more aggressive positioning as compared to the beginning of the year.
There is little fear of a meaningful market drawdown.
The rotation away from an exclusive list of large tech companies (FAANG) and broadening out of the markets appear hesitant and indecisive.
Valuations remain extended -- especially when measured against interest rates -- the equity risk premium is as low as its been in nearly two decades:
As a consequence of these headwinds and many other factors that we have previously expanded on lately in my Diary, I believe there is a growing possibility that the S&P 500 has already hit a high for 2023. It is our current expectation that a market decline may already have commenced and that, in the months ahead, the U.S. stock market may become far less forgiving, providing us with an opportunity to expand our long book at attractive prices.
Once the reality of "slugflation" (sluggish economic and corporate profit growth with stubborn inflation) becomes more accepted by the consensus, stocks will likely retreat to more attractive levels.
(This commentary originally appeared on Real Money Pro on August 16. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)