I hope that all of you who celebrate had a wonderful Easter last week. I just wanted to provide a quick update, as the markets have been quite tumultuous of late. We are done with Big Bank earnings for the 1st quarter of 2022. The overall message was enormously positive. Both consumer and commercial credit is as strong as it has ever been and are likely to stay that way for another year or so, before normalizing. The average deposit account has significantly more in it than prior to the pandemic. Consumer spending is very robust due to low unemployment. With all of that said, there are clearly a litany of major headwinds impacting both the economy and the stock market, and volatility was very robust this week, culminating in a major selloff the last day and a half. The indices were all down by nearly 3% on Friday and are down over 5% from their high’s on Thursday. We’ve now seen 4 straight weeks of losses in the equity markets, while bonds have been flailing as well.
The almost certainly manipulated government inflation data has inflation growing by 8.5%, and the real numbers are in the mid-teens when you fully account for housing/rent prices, which have sky rocketed. This has the Federal Reserve playing from behind, which has caused bonds to have their worst selloff in many decades. Many long-term bonds are down by 10-20%, which is simply staggering, and is simply a result of interest rates rising, as opposed to default risk. Mortgage yields have basically doubled from their lows. Thus far housing remains very strong, but at some point the lack of affordability is likely to cause a bit of a slowdown, although the fundamentals are significantly better than prior to the Great Recession, so I wouldn’t expect the worst in that regard. The S&P is down about 10.82% YTD and the Nasdaq is down considerably more than that. The QQQ ETF is down 19%. The Russian/Ukraine War continues unfortunately, which is further exasperating inflation, including the real possibility of major food shortages emerging as this year progresses. China continues to wage its pyrrhic, supposed Zero Covid strategy, with the most aggressive lockdowns we’ve seen yet in major cities like Shanghai. There are videos of tens of thousands of people screaming that they are starving in major metropolitan cities in China. This latest human tragedy will further pressure supply chain issues and is clearly a major negative for the global economy.
Tech stocks have really started to crater, with many of the biggest beneficiaries of lockdowns/work-from-home, losing all of their gains from March 2020. Netflix surprised the market with subscriber losses and the stock dropped 40% this week. It is now down 64% YTD, trading at $215, a far cry away from its 52-week high of $700.99. Salesforce.com is down 26% YTD, Zoom is down 45.64% YTD, Facebook is down 45.62% YTD, and even Tesla is down 16.23% YTD. The biggest winners this year have by far and away been energy and natural resource stocks, which have seen absolutely massive gains, making up for many years of terrible performance. Things move quickly in financial markets and one can go from hero to zero in an instant. Look no further than the hottest fund manager of the last several years, Cathie Wood, whose Ark Innovation ETF is now down 45.91% YTD. At a recent price of $52.46, the fund is down over 60% from its high of $132.50.
Our strategy going into this year was cautious. We have mostly been selling long-term cash secured put options, way out of the money, on stocks that we would be more than happy to own at the strike prices we are selling the puts on. The crash in high quality companies such as PayPal, Facebook, Netflix, Google, etc., have caused some of the best businesses in the world to trade at relatively cheap prices. The prices where we have been selling puts at are even cheaper, where we feel we would have 50-100% return potential within 2-3 years upon being exercised. These are businesses that generate huge returns on invested capital and have the potential to grow for many years to come. A lot can still happen so we’ll see if we actually get exercised, or if we will just make the money on the options that we have sold, which would put us up nicely on the year, despite the negative markets thus far. Either way we are very comfortable and this conservatism has saved us from taking the substantial losses that many have taken. It’s important to note as we like to reiterate, that you will only see the full benefit of the protection when most of the options expire, which for us is late January 2023. I’d estimate that even if all stocks were at the same prices they are currently, our average account would gain 10-15% simply between dividends and options expiring between now and then to put things into perspective. If we get a bit of a rally between then and now, we could end up with an absolutely fantastic year as there is huge upside on many of these names, so let’s hope for the best.
Almost all market participants say they would love to buy stocks if they went on sale, but pessimism is rampant now that we are actually seeing that unfold. Stocks don’t go on sale when all the news is good so fighting the psychological battle is paramount. Looking under the hood of the companies we are invested in, I’m extremely optimistic. We certainly didn’t foresee this tragic war from occurring, but I do believe that return prospects are quite attractive from current levels. Many stocks such as the banks, are pricing in a severe recession. The recently adopted CECL accounting forced the banks’ to reserve for all expected losses in a full credit cycle on their loans. They have added to those reserves, so they are more than prepared for a significant recession, and would almost certainly still generate very substantial profits, especially when you factor in the higher rates that we are going to be seeing as the year progresses. I’m excited that we have been able to get attractive exposure to many great Tech companies at huge discounts, with more to come as the year progresses. Most would never have believed we could buy these stocks at these levels, but here is the opportunity.
Some stocks will bottom before others, so while I’d guess we will see more downside in the indices, that doesn’t mean you should be sitting on the sidelines, especially when we have the opportunity to sell puts to manufacture cheaper entry prices, and to take advantage of this volatility. Potential positive catalysts would be peace in Ukraine, inflation slowing down, the economy staying resilient etc. The whole key to realizing good returns is letting the strategy do what it does. Right now options on just about everything are expensive because fear is substantial, but at expiration, the only thing that matters is where the stocks are relative to the strike prices, and even then our worst case scenario is owning stocks we think are deeply undervalued. I don’t expect the next decade to be like the past 13 years have been. Valuations are far higher, rates are going up, inflation is rampant, etc. We have to be able to handle much more volatility, and likely a more rangebound market, which is where individual stock selection and our income-generating options strategies should give us an advantage. I know it is easy to buy into the pessimism, but understand that we don’t need a really positive environment to make money with the strategies that we are employing. Patience, discipline, and not panicking when things look tough, are the seemingly simple characteristics necessary to be rewarded in this environment, and I’m confident we will be in great shape when all is said and done.