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The Brave Report: Market Commentary for March 2021

Click here for .pdf version of this report: The Brave Report-March 2021

Sell the froth…. With major averages rallying to new highs during the month we started to see some of the very lofty valuations get called into question. Over the past few months, we have seen some amazing rallies in a number of names simply based on their story about the future.  These prospects for future growth vaulted some names to dot-com era valuations.  As interest rates rose throughout the month these valuations started to get called into question and we saw a rush to the door and a rotation away from some of these highflyers.  While much of this selling can be justified, we have seen this selling capitulate a bit and even the tech names with strong fundamentals and more reasonable valuations get caught up in the rotation to more economically sensitive sectors.  Is this rotation going to just be a short-term correction or will this rotation stick as we see the economy accelerate as it opens up?

Market Overview

After selling off to end the month of January, the major indices all rallied to new highs in the middle of the month of February.  From there, we saw a bit of bifurcation as a small rotation away from tech stocks and into the more economically sensitive reopening stocks occurred to close out the month.  When the dust settled, the DOW gained 3.17%. The S&P 500 moved higher by 2.61% and the NASDAQ settled slightly negative on the month.  Optimism of progress on the virus front and rising interest rates led to some selling across the tech space.  There was some profit-taking in the high-flying names and some continued consolidation in the larger tech space.

On the fixed-income side, rates jumped sharply, especially on the long end of the curve.  The 10-year treasury bounced from around 1% in late January to above 1.5% to close out the month.  This was one of the sharpest moves in rates we have seen since the pandemic began.  Fears about rising inflation and uncertainty about how the Fed will manage rates as the economy recovers caused a rush of selling throughout the month.  Even with this sharp jump in rates, it is important to point out that rates still remain historically low.  Prior to the pandemic the 10-year treasury has only yielded below 1.5% twice in history (2012 and 2016) and in both instances, it was for a very brief time.

This rapid rise in rates has brought bond prices close to an oversold territory and with it some downward pressure on some of the more interest-rate-sensitive areas of the markets.  Optimism about the economy bouncing back and a fear of inflation caused more selling in bonds than we have seen in a long time. However, it is important to point out that rates remain historically low.  We also have a long way to go before the economy returns to where it was before the pandemic.  The Fed has shown no signs of tightening or raising rates and while the recent pressure on rates has been to the upside, I think we could settle into another trading range while the next move is determined.

The reopening trade has also been driving the markets in recent weeks as optimism over case numbers and the vaccine rollout has led many states to loosen their restrictions around the virus. I do think this presents a great sense of optimism for the country and the economy, but I also think it is important to acknowledge that we are not just going to hop back into business as usual and the economy we return to, in the short run, could look a lot different than it was a year ago.  Many businesses have been shuttered and consumer behavior has changed.  There could also be a lasting reluctance for people to resume their previous activities as fear has been the default mindset for many.  Yes, I believe there is a pent-up demand across many populations in the country, but that demand will be slow to be satisfied in many areas. I continue to think the economy will make a strong recovery, but I would also stress patience as you look to use this as an investment theme.

One of the other big stories we saw to end the month was weakness across the large tech space and in some of the stay-at-home names.  This caused a swift sell-off in the NASDAQ and a rotation in the sectors that are leading the markets. While this may seem like a new variable in the market, this rotation, especially from big tech has been going on for a while.

Coming out of the pandemic lows back in March 2020 the large tech names were the ones that led the rally. Amazon and Apple were up around 100% from the March lows at one point. However, over the past 6 months, the story has changed.  The major indices have all continued to rally but we have seen a rotation out of these large tech names and into other areas of the market. Of the five largest companies in the US (Apple, Amazon, Microsoft, Alphabet and Facebook) only Microsoft and Alphabet have seen positive returns with only Alphabet outperforming the S&P 500 in the trailing 6 months (Amazon and Apple are actually down over 10%).  During this same timeframe, the S&P 500 is up over 10% and the small-cap Russell 2000 is up over 42%.

This sharp rotation can be attributed to several factors. First, and foremost, these larger tech names rallied so much coming out of last year’s March lows that they were due for a period of consolidation. With the pandemic in full swing last year there were a lot of uncertainties about if and when the economy would recover, so a lot of investors piled into these larger tech names as a safe haven. Now that we have some clarity that the economy is coming back that haven is no longer needed, and we can now better project out revenue and earnings for the economically sensitive sectors of the economy.

Second, rates have risen rapidly in the last month which puts downward pressure on higher growth stocks since the higher-yielding bonds become a more attractive alternative.  The higher yields can also increase borrowing costs for companies making it more expensive to raise capital. The increased rates also change the valuation equation. As the discount rate rises, future revenue and earnings become less valuable. At this point, I think this reaction is a bit overdone, as rates still remain extremely low. This is especially true for the larger tech companies who have proven current earnings and revenue and also have record levels of cash on hand.  The more speculative, narrative-driven, stocks with negative cash flows could be impacted more as rates rise. Their valuation is more based on expected future cash flows so are more sensitive to this change in the discount rate.

Lastly, as we saw aggressive buying into some of the high-flying, more speculative stocks, investors needed to raise capital somewhere.  The obvious choice was to pull cash from their highly liquid winners.

While this type of rotation is normal and natural it seems to go against recent fundamentals and earnings.  Many of the names, especially the big tech names, just put through some of their biggest quarters ever, with many even raising guidance, but have sold off since.  So with this recent rotation and the overall markets still very close to their all-time highs where can we look for the next opportunity for gains?

As a long-term investor, I am always looking for areas of the market where the stock prices have lagged fundamentals and potential growth prospects.  In this case, I think some of the rotation into the more economically sensitive areas of the market can be justified.  While some sectors, like energy, have rallied a bit too fast, there are still some opportunities in Industrials, Materials and Consumer Discretionary. If you are underweight any of these sectors, I think increasing exposure would be prudent.

Additionally, while I may have missed the boat a bit rotating out of some of the big tech names a few months ago they now present an opportunity. This opportunity is not exclusive to just big tech but as we look across the tech landscape, we can identify companies that performed well during the pandemic but also will perform well in a reopening economy due to innovation and shifts in consumer behavior. Now, this is not about advocating for any individual stock but there are several great long-term opportunities that are sitting at or near extremely attractive entry points from a valuation standpoint. I would be comfortable entering or adding to most of the large tech names at these prices. These are not short-term trades, but an opportunity to add quality to your portfolio at an attractive price. They may not be as exciting as speculating on Gamestop but the best time to buy them is when they are unloved and have pulled back or consolidated for a period of time.

Lastly, I would continue to stress caution in many of these high-flying “euphoria” names.  If you are a seasoned day trader, feel free to dip your toe in but there are a number of names across the market that have rallied too far too fast based on little change in underlying fundamentals. I am not just talking about the WallStreetBets names but there are a lot of speculative names that have run far past any expectation of earnings. While making a quick buck may seem tempting, unless you are a disciplined short-term trader, I would advise against getting involved.

Strategy Commentary

My overall equity exposure has increased slightly in the last month as I have started to buy some of the beat-up names and sectors over the last week or so. While we have seen some weakness in some areas of the market, specifically in technology, the prospect for economic growth coming out of the pandemic remains intact.  With the recent pullback, I will be looking to add to some equity positions as the opportunity presents. This may be in the form of increasing my overall equity exposure but for now, it has just been some internal rebalancing.

Domestically, I am still maintaining my overweight to technology. While this has been a painful place to be over the past few weeks, I think the selloff is a bit over down. Obviously, it would have been nice to properly time the rotation out of these names but the long-term story in this space is still intact.  I may even add to some names in the sector.  I am also still bullish on industrials, materials and consumer discretionary and will be looking to add to some names because they should benefit from the reopening economy.  The other shift I have made over the past two months is to decrease my large-cap exposure and increase my small-cap exposure, on both the growth and value side.

Internationally, I am maintaining my stance on Europe and although China has sold off quite a bit in the last few weeks, I will continue to add to my positions there.  They seem to be leading the world out of the pandemic on the economic front and the long-term upside can’t be ignored.

While I am not fully underweight fixed income, I continue to prefer a larger cash position to a full fixed income allocation. With rates rising over the last month, this strategy has paid off.  If we do see rates start to top out, I may look to increase some of this exposure.