To Our Investors and Friends,
For the first time in a very long time the Magnificent Seven began to weaken (down 70 bps) as the rest of the S&P 500 strengthened during the month of August, finishing up 2.3% for the month. Concerns of a potential recession grew, driving the 10-year Treasury Bond lower to 3.91%, an 18-basis point decline from July as inflation continued to moderate and unemployment to tick up. The 2-year Treasury ended the month 38 basis points lower to end flat vs the 10-year, which has not been seen since before the Federal Reserve started to move rates higher. Oil remains at year-to-date lows, finishing the month at $76 a barrel. Despite the weakening of the largest companies in the index, it remained a large cap dominated market. The Russell 1000 Value Index finished 2.7% higher, the Russell 1000 Growth Index grew by 2.1%. Fears of recession helped push the Russell 2000 Growth Index down 1.1% and the Russell 2000 Value Index to decline by 1.9%.
This past month, the market Volatility Index, or VIX, moved from what has been a steady range of between 11 and 20 all year to a high of 66 on August 5th. On this day, the Tokyo Nikkei 225, the major Japanese index, plummeted 12.4% in a day, the worst decline it experienced since October 1987. The trigger was The Bank of Japan’s move to increase interest rates to .25% on July 31st as the rest of the world looks to start cutting rates. This increased the costs of capital many hedge funds were borrowing to buy stocks and prompted them to liquidate their positions. What ensued was a major unwind of positions that occurred simultaneously around the world, and a resulting flash crash. The VIX had last been seen at this extreme level at the onset of COVID in March 2020, and before that at the onset of the financial crisis that began with the collapse of Lehman Brothers in October 2008.
We believe that the shock was not triggered by an economic event that market participants were reacting to as they have in the past but is an indication of how the stock market participants have changed. Market participants themselves are now highly concentrated, which can lead to significant volatility for the most minor of events. More than 50% of equity investments in the US markets are now in passive indexes -- the largest amount in the S&P 500 Index -- up from about 10% at the time of the financial crisis. Of the actively managed funds, a large percentage of these investment strategies are directed by algorithms that are programmed to do some variation of the same trend following strategy – buy what is going up and sell what is going down. Add these two groups together, and the concentration of actions leads to the extreme volatility that we see today among individual stocks, sectors, and the major indexes themselves. This is precisely what Economics Professor Nassim Taleb warned us about in his book Antifragile.
As can be seen in the chart below, such robust, one-way trading is leading to a growing number of notable bearish to bullish stock reversals – situations where a stock moves from being severely punished by the market to rewarded in a relatively short period of time – during times in which there is no change to the fundamental trend. We can see that software producer Intapp (INTA) declined 33% earlier this year to only fully recover this decline in the last three weeks. Next generation credit provider Affirm (AFRM) dropped almost 60% this year before almost fully recovering from the decline in the last three weeks. This is coinciding with similarity extreme bullish to bearish reversals – Super Micro (SMCI), the most recent example of this, advanced over 300% through March of this year and since then has given up all but 53% of the gain.
We believe that the one-sided trading focus of algorithms is creating some very scary upward moves in stocks leading to valuations that may take years for the businesses to grow into. Conversely, there are also some incredibly attractive opportunities as some stocks drop to valuations far below what their fundamentals would suggest they are worth. It just takes a little thinking to appreciate these overshoots, which is far too much to expect from the algorithms. Once the trend changes direction, however, we can be sure that the algorithms will fall right in line, supporting the new direction of the trend.
At Kingsland Investments, we spend our time seeking and discovering the emerging leaders of the digital economy. Unlike the algorithm-based strategies, we focus only on these companies that we think will become much larger in the next several years, and therefore will have the fundamental strength to support a meaningfully appreciating stock price. We leave the fads and fashions of the moment to the algorithms that will drive such stocks higher and then lower in the blink of an eye.
All the best to you,
Arthur K. Weise, CFA