The S&P 500 closed out its worst January since March of 2020, declining by 5.3%, despite two strong rallies to end the year. The Nasdaq fared even worse, declining by 9%. Stalwart stocks such as Microsoft, Netflix and Nvidia even declined 7.5%, 19%, and 17%, respectively. The primary culprits for the selloff are concerns relating to future interest rate hikes and inflation. The worrisome inflation data makes it difficult for the Federal Reserve to maintain its ultra-accommodative stance that it has taken for most of the last 13 years. This has rattled this low-rate addicted market, as it could pressure valuation levels as nearer-term cash flows become more valuable once again, as one can earn higher rates on their other investments. In this challenging environment, I’m very happy that we were able to both protect capital, but also generate gains. Just as importantly, we planted the seeds for future returns with some of the investments that we made during this chaotic selloff.
I’d like to caution you though that this recent two-day rally has some hallmarks of a bear market rally, when these tremendous bursts of upside come from time to time. For the last two years, I’ve mentioned that valuations have become more stretched than at any time in history with the exception of 2000. In addition the relative valuations between growth and value stocks are right near the widest ever. These two factors, combined with higher rates, makes indices a very dangerous place to be in my opinion.
At the image on top of this email, you can see a chart of the Nasdaq from 2000-2002, when it dropped a staggering 83%. That selloff didn’t occur at one time, but instead saw intermittent rallies, followed by lengthy declines. I’m not saying the Nasdaq will drop by 83% by any means, but it hasn’t even dropped 20% yet. While it is tempting to buy every dip, and it has been immensely rewarding over the last decade, that isn’t always the case. This is why we are maintaining a strict discipline with our investments and are mostly taking advantage of the immense volatility to sell cash-secured put options and covered calls at elevated premiums, far away from current market prices. As we’ve discussed, often these options would be profitable even if the stocks decline 25-50% from current levels, at expiration. If we end up owning the stocks at these levels, we believe we could earn extremely robust returns over the next 5 years as the market recovers. Options are a valuable tool when used systematically, particularly in combination with extensive fundamental analysis to the underlying securities. That is the unique combination that I feel gives us an upper hand in this type of environment.
While there has been a lot of bad news out there, the good news is Covid-19 is declining once again. This trend should continue, which augurs well for more reopening’s and less employees missing work due to sickness and protocols. Earnings have been great and the overall economy should still be decent to good, barring any major changes in the short-term. The supply chain is still a mess, as the ships are still littered throughout the coast off of California. Hopefully that situation sees further improvement over these next few months, as that would really remove some big barriers hurting the economy from performing better. Many of you might have noticed that we’ve been selling puts on some of those technology names that have crashed by 50-75%. We’ve always liked the sector, but we only want to buy them when they trade at discounts to our intrinsic value estimates, so it is exciting to be able to get access to some of these excellent businesses at good prices. Lastly I want to make one point. While higher rates are generally good for our bigger investments, we don’t believe the economy can handle too much of an increase at this time. I hope it can, but we aren’t betting the house by any means that we’ll see several years of rate increases. If it happens we should do great, but if it doesn’t we feel we should do well too given the strategies being deployed. We’ve been dealing with low rates for the last 14 years, so it certainly isn’t something we aren’t prepared for if that did come to fruition.