Nvidia: 10x Tech Titan

I hardly ever write blog posts about individual stocks (see my DISCLAIMERS below!)  However, the astounding performance of Nvidia (NVDA) over the last two years has been absolutely amazing and is certainly worth an update.  From its recent trough on October 14, 2022 as the Fed tightening cycle was heating up through Friday, the stock is up more than 10x (split-adjusted price of $125.8 / $11.2 = 1,022%) per chart below!

 During its ascent, there were daily blips where the stock was down as much as -10%, but it countered that with nice rebounds.  Its daily standard deviation of return was +/-3.5%, meaning there was a very high probability that the stock could go up/down by 3.5% in any one day.

 What makes this performance even more astounding is that this is not some penny stock with limited coverage going from $0.25 to $2.50.  Nvidia is a large cap stock with billions in gross revenue and a large following of institutional and retail analysts and ownership. 

 I last wrote about Nvidia in February 2024 when it was only amazing!  At that time, I highlighted its situation as follows:

This tech company, in the old days simply known for its high-performance graphics cards for gaming and video, found itself in an almost amazing business situation.  Perhaps serendipitously, Nvidia found itself with a chip architecture and design that made it perfectly suited for a multitude of new applications other than gaming!

The new applications started with crypto and crypto mining… then, it migrated to self-driving cars, other devices and robotics needing video recognition.  And now, the beginning of the AI revolution finds Nvidia with another large product niche that makes its chips highly in demand.

Combine this product demand with the very scalable manufacturing process of computer chips and you come up with drivers of both top line and bottom line growth.  Sort of analogous to a drug maker who finds out that its one drug cures not only headaches, but many other maladies – all while production is hugely scalable!!

 Since then, it has continued its upward trajectory with higher revenue, earnings and market share.  The company has already disclosed product plans for the future, thus building up anticipation for new chips with better capabilities and energy efficiency.  The reported 85% market share is a built-in market for its proprietary next-generation chips and services.

Plus, given its astounding growth, new additional technical market factors come into play.  For example, Nvidia went from the third to the second largest holding in the $72 billion SPDR Select Technology ETF (XLK) with a 20% allocation.  So, 20% of every new dollar invested in that popular ETF will be invested in NVDA; a built-in market demand for that stock as new money flows into technology.  Likewise, NVDA has a 14% weighting in the $77 billion Vanguard Information Technology ETF (VGT), a 14% weighting in the $20 billion iShares U.S. Technology ETF (IYW), and a 20% weighting in the $20 billion VanEck Semiconductor ETF, not to mention its 6.5% weighting in the $500 billion iShares Core S&P 500 ETF (IVV) and others.

As a Chartered Financial Analyst (CFA) charterholder, I am well aware of the methods used to estimate equity values of companies.  However, I am also well aware that pure fundamental and technical analysis does not guarantee that a stock will be anywhere near what an analysis could indicate.  But, if someone wanted to write a story about a stock that had the best prospects for continued growth and return potential, then Nvidia might be IT!

This report is for informational purposes only.  The information, data, and analyses contained herein include confidential and proprietary information and other information from third parties.  The information provided is believed to be accurate, but the accuracy and completeness of the information is not guaranteed.  Past performance is not indicative of future performance.  This report is not an offer or a solicitation of an offer to buy or sell any security.

2024 Q2 Market Update

The U.S. economy has defied all fears of recession and over blown inflation since the Fed tightening cycle that began in March 2022.  In fact, Fed Chairman Jerome Powell coyly remarked in response to a “stagflation” comment on May 1 that he has not seen the “stag-“ or the “-flation” that would cause him concern.

The capital markets have agreed with this belief as U.S. markets continue to show pockets of strength and many new all-time highs in Q2, led once again by mega-cap tech stocks in the S&P 500 (IVV) with a robust YTD performance of +15.3%.  Though it is tempting to call this “irrational exuberance”, in most cases earnings growth has met/exceeded expectations validating the price strength of the large cap companies in that index.

However, many U.S. capital market sub-indices continue to lag the S&P 500 and produced negative performance during Q2.  Per the table below, small and mid caps (SCHA and SCHM) lag the most in Q2 (but still positive YTD) with high-quality dividend (DVY) struggling to stay even.

We are happy to finally see emerging market equities (SCHE) push forward due to some new strength in China and Taiwan and lead the broad capital markets during 2024 Q2 with a return of +5.3%, though still lagging the U.S. on a YTD basis. Lastly, fixed income, in the final throes of the Fed’s tightening cycle, are still seeking a firm ground from which to build.  Core bonds (SCHZ) are flat on the year, with shorter bonds (SLQD) and high yield bonds (HYG) a bit better.

My 2024 Q2 blog posts focused on three major themes:  investment strategy, portfolio diversification, and economic indicators.  Each of these themes is expressed in my role as an investment adviser per my blog post, Portfolio Management Decision-Making:

There are literally an infinite number of combinations of equities and fixed income to create a portfolio with similar levels of risk, so SOMEONE needs to make an investment decision and invest in SOMETHING!  That is my job, as an investment adviser, to use my experience and knowledge of the markets to understand client objectives and goals to create an appropriate diversified portfolio with a target level of risk.

My 5-year Blog-A-Thon!

I started writing weekly blog posts way back in late 2018!  I target one every week, but sometimes it’s every two weeks.  I write them because it’s a way for me to focus and summarize my thoughts on the markets and to express what I think is important.  It is also a way for me to let my clients know that I am always thinking of them!

As you may be aware, I have been playing around with the artificial intelligence utility called ChatGPT to see if it has any direct business uses for D&A.  Right now, it is mostly a fun toy to play around with but I don’t doubt that one day its power will make it invaluable for all aspects of business and society. 

One of the major uses of ChatGPT is to analyze and summarize large blocks of text and data.  It can also “write” blog posts on selected topics, but I have not used it for this purpose and will continue to write my own original blog posts.  However, one good use of this ChatGPT functionality is to help me analyze all 260 blog posts I have written over the past 5 years to help me summarize the main themes I have covered. 

Per the table below, I think it did a good job summarizing my focus over the last 5 years!  I am happy to report that the lion’s share of the thoughts expressed from my blog posts centered on market analysis and investment strategies (50%) since that is where I strive to provide the highest level of service to our clients. The second tier of focus dealt with specific asset classes (20%) and then retirement planning (15%) with the remainder dealing with behavioral finance and other topics.

Occasionally, I will write blog posts pertaining to a specific client concern or situation (anonymously, of course!)  So, if there are any unmet needs for clarification on certain strategies I have employed or if anyone simply would like to read my thoughts on a certain topic, please reach out and I will work on it for you.  Thanks!

Federer, Forehands and Finance!

My daughter lives in Hanover, NH and is a big tennis fan, as am I.  We were thrilled to learn that Dartmouth University invited tennis star Roger Federer to speak at their commencement on June 9 this year!  He focused his talk on “tennis lessons” that made me think about how playing tennis and investing have many parallels.

Certainly, both involve strategy, planning, adaptability plus a bit of luck!  In tennis, you need to anticipate your opponent’s moves and plan your shots accordingly.  Similarly, in investing you must anticipate market trends and make strategic decisions about where to allocate resources.

Both also demand continuous learning and adaptability.  In tennis you constantly refine your skills and adapt to different playing styles.  Hitting a strong inside-out crosscourt forehand to your opponent’s weaker backhand is a path to probable success.  Likewise, in investing you need to stay informed about market changes and be ready to adjust your strategies.  When the Fed telegraphs a dovish interest rate forecast, it is best to modify strategy accordingly.

Also, patience and discipline are crucial in both areas.  In tennis, staying calm and composed helps you make better decisions on the court.  Don’t rush that put-away volley, or you might hit it out or into the net!  In investing, maintaining a disciplined approach can help you navigate market volatility and avoid impulsive decisions.  Don’t chase that high-flying investment theme unless there is a strong case supporting it.

And finally, luck is also a factor in tennis and investing!  There are many unpredictable aspects to tennis like “net cords” where the ball just trickles over the net, gusty wind conditions, or bad ball bounces.  In investing, sometimes the markets move in unpredictable ways that are either to your detriment or benefit.   The timing of cash flows into the market could also be a positive or negative factor depending on when you entered the markets.  Also, unexpected economic or geopolitical events can significantly impact market returns.

While luck can influence outcomes in both tennis and investing, skill and preparation often mitigate its impact.  Both in tennis and investing, a well-prepared investor is better prepared to capitalize on lucky breaks and to recover from unlucky events.  Just like having a diverse selection of shots and skills in tennis helps your game, likewise diversification in investing helps mitigate risk.

And Still Champ!

The facts cannot be overstated!  The S&P 500 (IVV), as a broad-based stock index of the largest companies in the U.S., reached new all-time highs last week and has continued its phenomenal run of outperformance over the past 15 years!  Amongst the major asset classes like small- and mid-cap U.S. equities and international developed and emerging market equities and others, not one has beat that index at best return AND lowest risk!

Per the chart below, we can see that the S&P 500 (IVV, the green line) had tracked close to the other major indices until pulling away starting in 2021 where other broad indices lagged. Amazingly, it has achieved its pack-leading compound annual growth rate of +14.4% per year with the lowest volatility amongst its group at 17.3%.

Numbers like these have led some to question the value of diversification. Simply put, owning anything other than the S&P 500 in a broadly diversified global portfolio has hurt performance. However, it's important to remember that no one could have forecasted this impressive streak of outperformance, and there was still a high degree of risk, albeit less than other competing asset classes.

 Over the last several quarters D&A has committed more client assets to the S&P 500, depending upon the client portfolio objectives, while also keeping bonds duration shorter than the benchmark and has thus reaped some benefits.  However, the remaining allocations to some diversifying positions have been a drag thus far this year.  Like I said in my most recent blog post, Strategic Insights for Market Success, we are patient long term investors and are committed to our outlook:

 “The U.S. growth picture remains robust and is broadening globally, with parts of Emerging Markets showing promise. Central bankers expect inflation to decline gradually, with no signs of widespread acceleration. We continue to favor the momentum and other factors and are sticking with small- and mid-cap as market breadth has started to gain traction.

In conclusion, while the S&P 500's performance has been exceptional, it's crucial to maintain a balanced perspective and consider long-term strategic investments to navigate future market conditions successfully.

Strategic Insights for Market Success

As a dedicated investment advisor at D&A, my primary focus is to ensure that our strategic and tactical positioning remains sound for our client portfolios. This requires extensive research and analysis of current market conditions. Over the past several quarters, our strategy has included overweighting equities, enhancing the quality of our equity positions, and maintaining a shorter duration in fixed income relative to core benchmarks. However, the dynamic nature of the markets necessitates continuous evaluation to determine if adjustments are needed.

Recently, I took part in a Northern Trust webinar titled "What’s the Market Missing?" which provided valuable data and insights influencing my current views. Here are some key takeaways:

Real Wage Growth and Consumer Spending:

Real wage growth in the U.S. is on the rise, likely supporting consumer spending going forward. However, high interest rates have increased the interest burden, especially for lower-income groups. This mixed impact on disposable income warrants close monitoring.

Inflation and Interest Rates:

Inflation remains a challenge for the U.S. economy, though it has been steadily declining. Notably, "core services ex-housing" inflation is on an uptick, attracting the Fed's attention.  With U.S. equity valuations elevated but within normalized bands, the "higher for longer" interest rate scenario could be a key determinant of future market moves.

Volatility:

Volatility has been unusually low, with recent averages well below the historical norm of 20%. Historically, volatility spikes can lead to asymmetric returns—markets tend to be more volatile on the downside than on the upside. Factors like value and momentum, which prefer volatility, have shown mixed performance. Since 2022, momentum has been the best-performing factor. We should be cautious, as volatility is unlikely to remain at these depressed levels for long.

Current Tactical Views and Recommendations

Currently, we maintain an overweight position in stocks over bonds.  The U.S. growth picture remains robust and is broadening globally, with parts of Emerging Markets showing promise. Central bankers expect inflation to decline gradually, with no signs of widespread acceleration. We continue to favor the momentum and other factors and are sticking with small- and mid-cap as market breadth has started to gain traction.

In the fixed income space, we continue our shorter duration bogey and underweight in investment grade bonds and overweight in high-yield bonds, aligning with the strong growth outlook. This positioning also hedges against the risk of being wrong about the inflation trajectory, especially given the negative correlation between stocks and bonds observed in Q1.

Conclusion

Our investment philosophy hinges on thorough market analysis and strategic adjustments based on emerging data. The insights from the Northern Trust webinar reinforce our current positioning but also highlight areas for vigilance, such as volatility and inflation dynamics. By staying informed and adaptable, we aim to continue delivering strong, risk-adjusted returns for our clients.

In the words of Jerry Seinfeld

I wrote a blog post on May 8 titled "Here's a TIP" that dealt with inflation and D&A strategies.  It was a bit dry and some of you may not have read it!  So, in hoping that I could make the topic more engaging, I asked our new artificial intelligence (AI) friend CHATGPT to re-write it in the words of Jerry Seinfeld! Take a read below!  I think you will find it entertaining since it capture the essence of what I was saying with a bit of comic spin:

So, let's talk about inflation. You know, that sneaky little thing that makes your dollar bill feel more like a coupon? Yeah, that one. People always say, "Hey, if you want to hedge against inflation, buy gold, buy commodities, buy equities." But you know what else they say? They say, "Hey, don't forget about TIPS!" No, not those little nuggets of wisdom your grandma gives you. I'm talking about Treasury Inflation-Protected Securities.

These things are like regular bonds, but with a twist. They're issued by the U.S. Treasury, so you know they're legit. And instead of just sitting there collecting dust, their returns are adjusted to keep up with inflation. Pretty neat, huh? But here's the kicker: Turns out, they haven't been the superhero we thought they were in the fight against inflation.

I mean, just look at the numbers! TIPS had some good years, sure, but when inflation peaked in 2022, they took a nosedive. Down 12.3% while inflation was up 8.0%? Ouch! It's like trying to fight fire with a water pistol.

And why did they flop? Well, it's all about the math. Low coupon rates, interest rate hikes – it's enough to make your head spin. Core bonds had it rough too, barely scraping by with a -0.1% average annual return. Talk about a close call!

Meanwhile, traditional inflation hedges like gold, equities, and commodities were out there flexing their muscles. They left TIPS in the dust, along with CPI (that's inflation, folks) and their dreams of being the inflation-fighting hero.

But hey, it's not all doom and gloom. There's a silver lining in this cloudy financial forecast. Turns out, diversification is the name of the game. Short-term bonds, high yield bonds, bank loans – they all held their own against inflation, and then some.

So, what's the plan now? Well, Dattilio & Ash aren't exactly rushing to buy TIPS anytime soon. But with interest rates on the rise, they might just become the belle of the ball. And as for gold? Well, hindsight's 20/20, my friends.

Instead, they're doubling down on core equities. Because let's face it, big companies know how to hustle. They're raking in those earnings despite the inflationary storm brewing. And sure, other equity diversifiers like REITs and international stocks might be struggling, but hey, a little diversification never hurt anybody.

So there you have it, folks. Inflation might be giving us all a run for our money, but with a little strategy and a lot of diversification, we'll come out on top. After all, it's not about how hard you fall, it's about how high you bounce back. And in the world of finance, that's the name of the game.

Here's a TIP!

Aside from the traditional inflation hedges like gold, commodities and equities, Treasury Inflation-Protected Securities (“TIPS) usually come to mind.  These securities are bonds issued by the U.S Treasury and are fully guaranteed.  They are different from regular bonds in that the total return earned from income and principal is adjusted to reflect inflation over the time to maturity.  How have TIPS done over the past few inflationary years in their role as an inflation hedge?

As we all know, the capital markets have all been up and down over the past five years.  What we may not have realized is that TIPS (TIP) have not been too effective an inflation hedge.  From the table below you can easily see that TIPS had a few good years and a few bad years; the bad years coming exactly when inflation peaked in 2022; actually DOWN -12.3% when inflation was up +8.0%!

The reasons for the underperformance have a lot to do with bond math and the low coupon rates that existed prior to interest rate increases that started in 2022.  That same phenomenon impacted core bonds (AGG) in a similar manner causing its average annual return over the entire 5.3-year period to be only -0.1%!  Over that longer time horizon TIPS did outperform core bonds, but not by much and certainly not enough to warrant an inflation hedge badge!

Also from the chart above, you can see that traditional inflation hedges like gold (GLD), core equities (IVV), and commodities (GSG) all handily beat TIPS and CPI (inflation) over that horizon. Interestingly, it is important to note that diversification in the fixed income universe paid off handsomely during this difficult period.

Aside from long term investment grade bonds (LQD) that have struggled in the face of higher rates, other fixed income sectors proved to be good diversifiers to help hedge inflation risk by outperforming core bonds.  Short-term investment grade bonds (SLQD), high yield bonds (HYG), and bank loans (BKLN) all outperformed TIPS and managed to stay close or beat inflation.  Some of that outperformance is due to a shorter bond duration and historically narrow credit spreads.

Dattilio & Ash has not been a buyer of TIPS during the prior market cycle. Higher rate levels today, however, may make TIPS a more interesting investment thesis going forward.  Gold, on the other hand, with 20/20 hindsight could have been a viable investment option over the past few years.  D&A had not been an investor in commodities due to their higher level of risk. 

Instead, we have focused mostly on core equities and shorter duration fixed income sectors and have consistently had total fixed income duration shorter than that of core bonds.  Shorter duration fixed income has less interest rate sensitivity and will outperform longer duration bonds when rates are rising in a Fed tightening cycle.

Core equities have been a good place to be as large stable companies are able to increase earnings due to inflationary pressures and D&A has been increasing allocations to this sector over the past several quarters.  Other equity diversifiers, like small- and mid-cap equities, real estate investment trusts (REITs) and international and emerging market equities continue to struggle to keep pace with core equities but we continue to hold for diversification purposes.

Video Blog - Market Views: A Long-term Strategic Assessment of the Capital Markets

In this 6-minute video blog post I highlight what the markets have done recently and over the past 10-years and discuss the relationships of risk and return of a few of the major asset classes.  I then integrate those thoughts into how we manage investment for clients.

Portfolio Management Decision-Making

I have written a lot about risk over the years and how it can influence portfolio management and market participant behavior.  For example, in 2022 many investors feared the developing market weakness and they “ran for the hills” by selling equities and buying bank CDs; thus, locking in losses and missing the huge recovery and new all-time highs in the broad equity markets.

Managing risk through portfolio management is as much an art as it is a science.  For a globally diversified portfolio and a given set of constraints, there are numerous approaches we could follow and many analytical tools (such as Portfolio Visualizer) we can use to help guide us with this task.  Let’s look at a few strategies that we could employ for a typical client.

Let’s assume you are a client with a long-term time horizon to retirement and want to maximize return as an aggressive investor with the capacity to accept a large amount of risk (20% standard deviation of returns).  Intuitively, we can guess that the target aggressive portfolio would be heavily weighted to equities with no fixed income allocation.  But, what exactly would this portfolio look like and what does the 20% standard deviation of return translate to?

Using the Portfolio Visualizer model, we can model expected results and get an idea of the details underlying these assumptions.  As you would expect, this aggressive model portfolio would generate large losses when the equity markets go down with a maximum drawdown of -30.16% but would generate a modeled expected return of +13.63% over a 10-year horizon (See table/chart below).  This portfolio targets the most aggressive sectors of the equity markets and is minimally diversified to help maximize returns; something a typical investor might not be comfortable with.   

Let’s say, however, that you are a bit risk-averse and instead want to target a lower moderate risk portfolio with a 10% standard deviation of return.  In that case, your fixed income allocation goes up from 0% to 26% and your maximum drawdown goes to only -16.13% with a modeled expected return of +9.37%. Interestingly, this modeled portfolio maintains a relatively large equity weighting, but this time it is allocated to the least risky equity sectors.

If you are somewhere in the middle, we can target a 12% risk and target a growth portfolio that results in a 10% fixed income allocation that generates a modeled return of +11.14%.  Again, this modeled portfolio targets the least risky equity sectors in lieu of a larger fixed income allocation to help reduce portfolio risk.

So, what does this all mean?  Models, after all, are only “models” and can only be used as a guide.  Quant investors, meaning those asset managers who rely on quantitative models to manage their portfolio, do NOT beat the market with any regularity over time so we know that models alone are NOT the solution.

There are literally an infinite number of combinations of equities and fixed income to create a portfolio with similar levels of risk, so SOMEONE needs to make an investment decision and invest in SOMETHING!  That is my job, as an investment adviser, to use my experience and knowledge of the markets to understand client objectives and goals to create an appropriate diversified portfolio with a target level of risk.

2024 Q1: Quest for "Normalcy"

Like a wilting flower, some of the bloom came off of the “Magnificent 7” during Q1 2024. Though Nvidia (NVDA) and Facebook (META) continued their phenomenal performance during Q1, the rest of the crowd came back to earth – and even struggled – with Tesla and Apple dropping -29.3% and -10.8%, respectively!  As the broad capital markets became more comfortable with the state of the U.S. economy, the S&P 500 (IVV) reached new all-time highs during the quarter and ended Q1 up +10.42%.  However, similar to previous rallies over the past few years, diversifying asset classes like small- and mid-cap U.S. equities and international and emerging market equities have lagged, but this time by a narrower margin. 

Though many imbalances remain in the U.S. economy, like housing affordability and pockets of unemployment, concerns about the U.S. economy are subsiding as inflation has fallen close to the Fed’s 2% target and growth remains strong.  Global tensions, however, are a crucial backdrop to market performance as the Russia/Ukraine and Israel/Hamas wars continue to cast uncertainty on the markets due to threats of supply chain disruptions and oil supply shocks.

Per the table above, we can see that most markets continue their recovery from the depths of 2022, with the S&P 500 (IVV) taking the crown for best performance.  Equity performance continues to be dominated by the “growth” story such that stable and mature companies, such as those in the dividend-payer space such as DVY, have not kept pace.  Fixed income has been a troublesome area with weak returns as the inverted yield curve works to right itself; long-end yields may rise as short-end yields may fall.

During Q1, I wrote blog posts featuring bitcoin, Nvidia and hydrogen; themed assets that are very topical with idiosyncratic profiles.  Though these all have potential for extraordinary return, they also have extraordinary risk per my blog post, Now What?  A Futurist View:

D&A believes in long-term strategic investing to help investors achieve their goals consistent with their time horizon, risk tolerance and special considerations.  The views of Cathie Wood are compatible with our philosophy as we both have a long term time horizon.  A fully diversified exposure to US and global equities will allow investors to capitalize on this view without adverse idiosyncratic risk exposure.

The Potential for Hydrogen?

Plenty has been written about clean energy since before Al Gore made his infamous documentary, An Inconvenient Truth, highlighting the effect of excess carbon dioxide on climate change.  A global push to reduce carbon emissions now exists and the emergence of a viable electric car industry is making an impact on our carbon footprint.

Most electric cars are simply cars powered by electricity stored in large batteries.  Other types of electric cars, termed hybrids, make use of small gasoline engines and electric motors that work in tandem.  But these are not the only types of clean energy cars.  A technology that does not get much publicity is electric cars powered by hydrogen fuel cells.

Hydrogen fuel cells produce electricity by converting hydrogen gas into electricity through a chemical reaction.  The technology is currently in use by some companies including Toyota but, despite its potential, has not gotten much traction.

Investors interested in this technology can participate by investing in exchange-traded funds (ETFs) that focus on this investment theme.  Three ETFs currently exist that cover this space: the Defiance Next Gen H2 ETF (HDRO), the GlobalX Hydrogen ETF (HYDR), and the Direxion Hydrogen ETF (HJEN).  As seen from the chart below, weak performance relative to the S&P 500 (IVV) has been the norm over the past 2.5 years.  Also, these hydrogen-themed ETFs have not attracted much investor interest since the combined assets under management for them continue to be well under $100 million.

There are a few ways to approach this from an investment perspective.  First, buy one of the themed ETFs shown above to get some exposure to the sector.  Another approach is to buy single-stocks that are thought to be market leaders in the space; a very time-consuming and laborious approach that does not guarantee success.

The biggest problem here, however, is that the macro picture is not very clear.  Despite all the efforts to push the clean energy agenda forward and potentially exploit the potential of hydrogen, there is still much to do and no guarantee on a time frame.  Just today (March 18), an article on CNBC highlighted comments from the Saudi Aramco CEO saying the “energy transition is failing” and the “world should abandon ‘fantasy’ of phasing out oil”.

Investing in hydrogen could be a viable strategy, but as of today it seems “too early”.  A lower risk approach to invest in this space is to wait for the markets to begin to show some strength based on some current growth and some firm growth potential before investing.  Otherwise, it would be prudent to stay fully invested in the broad U.S. large-, mid-, and small-capital equity markets and international exposure to have some exposure when/if that market develops.

Spot-on Bitcoin ETFs

We have all heard about cryptocurrencies and bitcoin.  The emergence of this “digital asset” has reached a new plateau of legitimacy given the approval of exchange-traded funds (ETFs) of spot bitcoins in January 2024; to date, about $10 billion has already flowed into these new ETFs!  Though bitcoin ETFs have been around since late 2021, those ETFs, were on bitcoin futures not on actual spot bitcoins.

Does this new development change the landscape for investors?  What can we expect going forward?

First, a quick description of bitcoins.  Bitcoins are digital assets created by digital miners using block chain technology and they only exist in cyberspace.  Bitcoins are scarce in that only a specified total volume of bitcoins are created.  Bitcoins can be thought of as an asset class that is traded amongst willing market participants, and even used as currency.  History has shown that bitcoin has a very high volatility making it a very risky asset class, but also with relatively low correlation to other asset classes.

You can’t hold a bitcoin in your hand.  Instead, you own it as an entry on your digital bitcoin account.  Owning bitcoin requires careful control of your account and passwords.  Though bitcoin adoption has been tremendous, some observers have felt that its growth has been limited by the perceived difficulty in holding it as an asset.  This is where the spot bitcoin ETF comes in!

Many market participants have likened bitcoin to gold as an asset class; “If you like gold, you will love bitcoin!”  Just like gold, bitcoin is a store of value and is a scarce commodity with limited supply.  However, unlike gold, bitcoin is easily divisible and tremendously portable.  Gold is difficult to cut into smaller pieces and certainly too heavy and difficult to transport.

Many market participants, including Mark Yusko of Morgan Creek Capital, have been huge proponents of bitcoin as an asset class.  His current market thesis is that the emergence of spot bitcoin ETFs have created a new and huge increase in demand for bitcoin as an asset class for market participants wanting some exposure by eliminating the difficulty in holding bitcoin.  Everything else being equal, the perceived increased demand given the limited supply leads him to a bullish view.

D&A has not bought bitcoin for any client accounts.  However, the advent of spot bitcoin ETFs may make it an acceptable diversifier for some aggressive accounts.  We will be following this market closely and report on it as our views crystalize.

Do you own Nvidia?

Nvidia, the current tech darling, has had a historic run and is now one of the best performing large cap stocks of all-time – up almost 400% over the last three years (see chart below, the green line at the top)!  This tech company, in the old days simply known for its high-performance graphics cards for gaming and video, found itself in an almost amazing business situation.  Perhaps serendipitously, Nvidia found itself with a chip architecture and design that made it perfectly suited for a multitude of new applications other than gaming!

The new applications started with crypto and crypto mining… then, it migrated to self-driving cars, other devices and robotics needing video recognition.  And now, the beginning of the AI revolution finds Nvidia with another large product niche that makes its chips highly in demand.

Combine this product demand with the very scalable manufacturing process of computer chips and you come up with drivers of both top line and bottom line growth.  Sort of analogous to a drug maker who finds out that its one drug cures not only headaches, but many other maladies – all while production is hugely scalable!!

If the bottom up and top down drivers of stock return are so bullish, why didn’t D&A buy it for its clients?  It is all about portfolio management and risk management!

D&A is philosophically committed to a globally-diversified risk-managed approach to portfolio management.  This approach precludes buying specific stocks that could expose portfolios to overweighted positions that could have an idiosyncratic risk profile, i.e., stock-specific risk.  For example, we are aware that Nvidia had a tough year in 2022 when it was actually DOWN -50%, but it recovered nicely in 2023 with an astounding +239% annual return.  Also, year-to-date in 2024 Nvidia has added another +46% return!  So lots of downside risk, but we have seen lots of upside risk, too!

D&A does believe that Nvidia should be a part of most investor portfolios, but only in a weighting that is consistent with a client’s risk profile and the broad indices that we follow.  For example, since Nvidia makes up 4% of the S&P 500, a client with a 30% allocation to the S&P 500 (IVV) would have a 1.2% allocation to Nvidia.  Additionally, since D&A believes in the momentum factor and invests in the iShares Momentum Factor ETF (MTUM) for some client accounts with a moderate/aggressive risk profile, since Nvidia stock makes up 6% of that ETF, a client with a 5% allocation to the MTUM ETF gains another 0.3% allocation to Nvidia.

So, most all D&A clients own Nvidia as part of the ETFs that we buy for client accounts; but only in an allocation that is consistent with the client risk profile.

Here We Go Again?

As readers of this blog are well aware, diversifying asset classes have had a difficult time beating core assets over the past few years.  Over shorter time horizons, such as during 2023 Q4, diversifiers have had some advantage, but we are starting to see large lags again as we enter 2024.

The S&P 500, once again overwhelmed by the performance success of the “Magnificent 7” – except for Tesla that has struggled mightily so far this year, is off to a good start.  The combined year-to-date (through Feb. 2, 2024) performance of Microsoft, Apple, Nvidia, Amazon, Meta, Alphabet, and Tesla that makes up a huge 27% of the S&P 500 is +9.1% compared to the S&P 500  (IVV) return of +4.0%.  The performance of key diversifiers like small cap (SCHA, -2.9%), mid-cap (SCHM, -0.4%), international developed equities (SCHF, -0.6%) and emerging markets (SCHE, -3.9%) pales in comparison.

So, what do we do?  Let’s look at the Callan Periodic Table of Investment Returns (see chart below) for a historical perspective.  As we can see, over the last 20 years the top annual performers were U.S. Large Cap (medium blue), U.S. Small Cap (dark blue), Emerging Market (orange) and Real Estate (red) with each taking top honors four times.  But, over the most recent last five years, U.S. Large Cap, i.e., the S&P 500, has been at the top three times!  And, over the most distant six years, Emerging Markets was tops three times!  The leader board has changed hands many times.

The idea, of course, is to have a well-designed mix of asset classes such that some “zig when the others zag”.  That has not been the case over the last three years with U.S. Large Cap being such a dominant leader.  Consequently, well-diversified portfolios over the recent past have actually LAGGED portfolios made up of less-diversified portfolios targeted only to the S&P 500. Can this go on forever?  History says NO, but we shall see.

D&A is a strong believer in a well-diversified portfolio targeted to an investors time horizon, risk preference/tolerance and special considerations to help meet their goals.   

Balancing Risk and Reward

Stocks or bonds?   Most people grasp the value of an equity position in a company.  In addition to the periodic payments of dividends, the value of the equity can also rise if the company or its prospects grow.  Just look at companies like Apple, Amazon, and Nvidia that have led equity markets with large returns over long time horizons!  Historically, broad indices of stocks (IVV) have produced annual total returns of about +10% over long time horizons.

 But, bonds seem a bit foreign to most people.  Though bonds start out looking like bank certificates of deposit (CDs) paying periodic interest payments with their principal value paid at the end of the term, they also can go up or down in value like stocks.  As we have seen, while interest rates were rising in 2022, core bonds (AGG) generated total returns of -13% while core stocks (IVV) were down -18%.   Over the longer term, core bonds have generated a total return of only about +3%. 

 If all we care about is “terminal value”, i.e., the value at the end of a chosen time horizon, and stocks generally outperform bonds, why buy bonds at all?  The answer lies with the definition of risk and the needs of the investor.

Interest rates from bonds today seem fairly attractive given the recent history of “ZIRP”, i.e. zero interest rate policy.  Short term Treasury bills currently pay a bit over 5% interest per year and longer term 10-year Treasury bonds pay a bit over 4%.  For a very risk averse investor, a 100% allocation to bonds today could help to generate about 4% annual total returns over 10 years.  Depending upon the specific needs of the investor, this could be a viable strategy.

However, for a young investor with a long time horizon and a good deal of human capital to earn income from their labor, they can generally accept more risk and can tolerate a larger equity content with more market volatility to potentially capture higher returns.

The chart below highlights the 16-year performance of core equities (IVV), core bonds (AGG), and three asset allocation funds with equity/bond allocations of 40/60 (AOM), 60/40 (AOR), and 80/20 (AOA).  As you can see, over this time horizon 100% core equities (IVV) led the pack with an annual total return of +10.5%, handily beating core bonds (AGG) with a total return of +2.6%.  As expected, as the equity content increased, total returns of the asset allocation funds increased with +5.7% for AOM, +7.5% for AOR, and +8.9% for AOA.

But, those higher returns came with higher risk from the equity component.  If you trace the green line (IVV, core equities), from its initial drawdown in 2008/2009 you can see that it took almost 5 years for its cumulative return to catch up to the returns from the 40/60 fund (AOM, gold line).  Also, the quantitative measures of volatility show much higher levels of risk for core equities (+20.2%) compared to core bonds (+5.5%) and the asset allocation funds.

D&A works with their clients to help determine an appropriate asset allocation and risk profile to help them meet their goals.  Some investors can accept more risk while others cannot wait five years for the markets to recover (like the green line above from 2008 through 2013).

Now What? A Futurist View

We just got through two very tumultuous years for the markets; down a lot in 2022, but up a lot in 2023.  The markets were bifurcated with defined winners and losers.  For example, techs were pummeled in 2022, but rallied strongly during 2023.   Certain sectors, including financials, struggled mightily without much recovery in 2023 due to the minor banking crisis in Q1 2022.

Also, prompted mostly by a hawkish Fed in 2022, bonds were down as much as stocks, but did not recover much in 2023 until the Fed signaled the potential to turn more “dovish”.  During the past two years the economy has resisted falling into a recession and inflation has receded nicely.  Additionally, all of this capital market behavior co-existed with troubling geopolitics and wars.  So, where do we go from here?  Do any “bets” make sense in this economic and market environment? 

There are plenty of forecasters (prognosticators?) out there.  We need to avoid “driving through the rear view mirror” so I favor the views of big thinkers who really look forward.  One such analyst is the (infamous?) Cathie Wood of tech investor fame.  She recently proffered her views of the future on a TEDTalk and it is well worth a listen on Youtube.

In it, she focuses on her identification of “five innovation platforms” that are evolving at the same time: artificial Intelligence (AI), robotics, energy storage, blockchain, and multiomic sequencing. The growth potential “reminds us of Amazon, 20-25% compound growth over 20-25 years” that potentially could be “sustained forever”.

One such revolution is the potential that exists in autonomous taxi platforms that converge energy storage, AI, and robotics.  The impact on transportation and business logistics is immense with “mid-boggling numbers.” Moreover, in her view, this productivity-generated real growth is disinflationary, if not deflationary.

In fact, Cathy Wood is blunt when she says she believes there is enormous productivity growth “the likes of which we have never seen” and “most people think we are crazy when we say things like this --- but we really do believe that real GDP growth around the world is going to accelerate from that 2 to 3 percent range into the 6 to 9 percent range and a lot of that will be productivity-driven.”

Ms. Wood closes with her final recommendation: “Get on the right side of change and hang on for the ride.  Because truth will win out and the opportunities are enormous.”

D&A believes in long-term strategic investing to help investors achieve their goals consistent with their time horizon, risk tolerance and special considerations.  The views of Cathie Wood are compatible with our philosophy as we both have a long term time horizon.  A fully diversified exposure to US and global equities will allow investors to capitalize on this view without adverse idiosyncratic risk exposure.

2023: Spotty Market Resilience

It wasn’t pretty and it wasn’t smooth, but in the end it mostly all worked out! A perfect scenario would include a longer term “catch-up” from all the broad diversifying equity asset classes; we shall see!

Certainly, 2023 was OWNED by the “Magnificent 7” (Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta) with a quick attempt at a catch-up during Q4 for everyone else!  Those 7 stocks overwhelmed the other 493 stocks in the S&P 500 with a combined +106% 2023 return helping the S&P 500 (IVV) close the year at +26.3%; just a smidge away from an all-time high!  S&P 500 performance, however, took a back seat during Q4 as small cap equities (SCHA, +14.7%) were best in Q4, with the S&P 500 still best for all of 2023; hopefully, the relative performance of small cap and other equity diversifiers can keep up the good performance into 2024 and beyond!

The economic backdrop and special factors in 2023 certainly supported this phenomenal recovery from 2022 (see table below).  It all started with a diligent Fed holding rates higher early in the year to help quell inflation.  Then, later in the year, economic statistics trended towards positive results with the Fed confirming a need to “pause” tightening monetary policy with a potential “easing” in 2024.  Combine this with the positive business dynamics of the potential for AI (artificial intelligence) to boost the tech business and potentially transform all businesses and there were plenty of reasons to cheer!  However, the troubling backdrop of raging geopolitics persisted including the Ukraine/Russia and Israel/Hamas wars.

The table above shows the relative performance of the major asset classes that I follow.  It is encouraging to see that all asset classes recovered mightily from the depths of Q3.  I reported back in Q3 that there were glimmers of hope for the markets including “mostly stable credit spreads in the bond markets, stable industrial production, stable unemployment, and rising consumer sentiment” but it seems that the Fed “pause” in Q4 was the impetus needed to propel all markets higher.

During the depths of Q3 when markets were struggling, it was easy for the negative market psychology to overcome rational thinking.  However, as I stated in my November 21, 2023 blog post, And Now For Something Completely Different!, some positive factors teased a recovery:

As it relates to the current market environment, we may be in the early stages of something modestly different in the form of an inflection point and some normalization of many of the key factors driving market returns.

"... An Inflection Point"

From my November 21, 2023 blog post, And Now for Something Completely Different!, I highlighted trends showing in several of my favorite factors that led me to think we are on the verge of a better market environment.  Prior to this, a negative bias certainly existed in the markets; and amongst some clients!

I noted mostly positive trends in factors including interest rates, inflation, unemployment, bond credit spreads, industrial production/capacity utilization and consumer sentiment and I stated that these trends “could be a positive sign for equities and fixed income”.  I cannot predict if the markets would go up or down, but the trends all pointed to the potential for a positive surprise.

Sure enough, the positive trends that were noted seemed to be confirmed by news on December 13 that the Fed could be done hiking rates and is contemplating cutting interest rates in 2024.

Certainly, “staying the course” was the right strategy to take and is paying off for D&A clients.  For example, the S&P 500 reached a new 52-week high today causing some cheer (see chart below)!  Also, many of the diversifying asset classes like small/mid cap equities and international developed and emerging market equities have rebounded nicely in Q4, but have more to go to catch up for their lag in all of 2023.

Fixed income, on the other hand, has been a good place for diversification since many of the sub-asset classes like preferred stock, high yield bonds, and bank loans, have done well in Q4 and all of 2023. Even short term bonds, that are now lagging long term bonds YTD, gave reason for cheer due to their superior risk-adjusted return.

I have been apologizing all year for the weak performance of the diversifying asset classes amongst the broad capital markets, excluding the Magnificent Seven, and have consistently stated that we need to “stay the course” and be patient because no one can “time the market”.

D&A conducted a few strategic tilts in most accounts that included improving the quality of equities and shortening bond duration – and then lengthening again, that helped improve the overall risk/return profile and help most accounts perform well against their benchmarks so far in Q4.  We are hopeful that it will continue into 2024 and beyond!

Round Trip Ticket?

I wrote about interest rates back at the end of October titled, “Timing is Everything!  In it, I reviewed the current Fed tightening cycle and how difficult it is to forecast interest rates, mostly due to the difficulty in understanding the timing lags implicit in every Fed action.

From the end of October (when I wrote that blog post) to now we have seen a dramatic swing in market interest rates!  Through July 2023, we had just seen 18 months of rate increases from the Fed causing short interest rates to rise precipitously from 0.25% to 5.50% and 10-year Treasury rates increase from 2.19% to 3.96% (see chart below).  Somewhat concurrently, the economy had started to show signs of slowing, thus prompting a thought that the Fed may be ready to end its tightening cycle to help quell inflation. Surely, a good time to lengthen duration!  NOT!

From August through mid-October the Fed skipped any more rate hikes while 10-year Treasury rates jumped to peak at 4.98%!  Though the causation is not clear, some economic statistics showed some strength that probably prompted fear of a resurgence in inflation with market participants now requiring an “inflation premium” to go out 10 years on the yield curve.  However, from that peak to now (December 6, 2023), we have seen the 10-year Treasury rate fall to 4.12%, thus implying a market view over that time horizon that the economy is NOT overheating, inflation is NOT accelerating, and the Fed is NOT likely to tighten again and, instead, is likely done with its tightening cycle and is preparing to loosen in the case where the economy begins to falter.

In perfect hindsight, from a total return perspective from July through December 6, 2023, one would have been indifferent to short versus long bonds since the total returns over this time horizon have been almost completely neutral (see chart below)!  In the fixed income world we just saw a classic “round trip” where a strategy of short or long bonds would have been a satisfactory investment strategy over that time horizon!  Short-term investment grade bonds (SLQD, the green line) marched slowly and sporadically higher in a narrow range, while riskier long-term bonds (LQD, the blue line) went on a wild ride ending up in the same place!

The lesson, of course, is to not try to time the market.  Maybe you could get lucky and time the bottom and top, but it is unlikely.  For long term investors, it is best to always stay diversified and plan for the long term!