As always, this is not investment advice! Please do your own due diligence and take your own financial situation into account. Everyone has a different financial situation, which means different tolerances for risk and ability to take risk. What is appropriate for me may not be appropriate for you.
During September, the Paper Portfolio returned -7.12% vs -4.75% for the SPY. This brings YTD returns to 21.9% vs 13.0%, respectively.
September played out very much as an echo of August with significant volatility throughout before staging a small rebound late in the month. Also similar to August, small caps significantly underperformed large caps.
The greatest surprise for markets over the past month was likely the September mid-month FOMC meeting. While the Fed decided to keep rates unchanged, markets were surprised to see Fed members raise their forecasted interest rates for 2024 and 2025, signaling “higher for longer”. While the dot plot still forecasts some rate cuts in 2024, the amount of cuts is now expected to be lower. The median Fed member now expects rates to end 2024 at 5.1% instead of 4.6% (vs forecast of 5.6% for end of 2023).
Source: Bondsavvy
The Fed noted that the change in forecasts reflects continued challenges in reducing inflation as well as greater-than-expected strength in the economy.
Although markets appeared genuinely surprised by the change, Capital Flywheels continues to believe markets are misinterpreting reality.
As we noted here last month, CPI was likely to rise near-term from recent low of 3.0% to 3.8%, which may cause some confusion leading into the September FOMC…this is very unfortunate because it was almost entirely predictable, yet, markets did not appear to be attuned to this possibility:
Near-term, the inflation prints will likely continue to be tricky. Inflation is and will likely continue to rise in the near-term on year-over-year basis. However, this mostly seems to be due to base effects given how inflation trended a year ago. The month-over-month data looks much less problematic. I will be watching the September CPI closely. Something tells me investors may scream and shout when CPI comes in somewhere closer to 3.8% (vs recent low of 3.0%). Even if the month-over-month data seems fine, the narrative / noise seems to be a story that will write itself. But what will the Fed do at their September meeting?
Source: Paper Portfolio – September 2023 Update
The actual CPI number came in at 3.7% just a few days ahead of FOMC, effectively in-line with what we had predicted. The rise in CPI likely played a role in Fed dot plot forecasts. However, Capital Flywheels believes FOMC members took the most sensible route. Given the rise in CPI, the Fed could have justified raising rates another time. Instead, the Fed chose to keep rates unchanged, while moving dots up. The benefit of this approach is that the dots can be changed at any time, and the dots are not a plan or actual policy. In other words, the Fed basically did nothing without having to look like they did nothing.
Why does this matter?
This matters because much like how we anticipated that inflation would rise near-term to around 3.8%, it is also fairly clear that this dynamic is temporary. As we described last month, a lot of the recent rise in inflation is mostly due to technical factors, which should reverse. Inflation is likely to begin to fall again as we head into the end of the year.
This last point should also be considered in the context of the PCE data (another form of measuring inflation) that came out right on the last day of the month. The latest PCE number came in softer than markets feared (especially given that markets were completely thrown off by what should have been a fairly predictable rise in CPI). The better-than-expected PCE threw markets for a loop and helped stage a very late month rebound in markets.
Capital Flywheels will also take the opportunity reiterate that markets do not need rate cuts to work. Markets simply need rates to stop going up. This may be hard to grasp, but it is likely the primary reason why so many market participants have been surprised by decent market performance this year, despite continuously delayed rate cuts. At the end of last year, market participants looked at Fed Fund Futures pricing in rate cuts in 2H23 and were skeptical (for good reason). However, market participants assumed that if rate cuts didn’t happen, then markets wouldn’t work. Now 9 months later, markets are looking at rates staying high until maybe 2H24. They were right about rates! But they were wrong about markets. Despite the delay in rate cuts, 2023 has been a strong year for markets because markets do not need rate cuts to work. Markets simply need rates to stop going up as we have suspected.
Turning to the Paper Portfolio, September was another challenging month. Despite what Capital Flywheels believes to be correct reads on CPI/inflation and FOMC, we all need to pay respects at the alter of the markets. The markets are not always efficient, but everyday as we ride the whale, we have to choose between what we believe is rational for the long-run or what we believe is most optimal in response to the whale’s most immediate understanding of reality. Perhaps as a reflection of personality, Capital Flywheels prefers the former. This allows us to be correctly positioned for major shifts in reality like in late 2022, but it also means we have a blood price to pay when the whale moves against us in the short term such as in August and September.
During September, there was only a single winner. Sea returned +16.8%. Sea is incredibly cheap, but markets have been concerned about rising competition and spend, especially against TikTok. However, Sea benefited from changes in Indonesian regulations, which will likely disrupt TikTok’s e-commerce operations in the near-term. Regardless, Capital Flywheels believes Sea and TikTok will coexist in the long-run. As long as Sea is not completely disrupted (which is what the stock is likely pricing in), there is likely enormous upside once the market is comfortable with the competitive situation.
On the negative side, there were many. I will not go through all of them, but Unity is worth a mention. Unity declined 15.3%. This was an interesting move because it happened largely after Unity announced price increases as well as new revenue streams. If it works, it promises to significantly improve Unity’s financials in coming 12-18 months. However, in response to the price increase, many developers expressed dissatisfaction, enough to get the company to roll back some of the changes. Still, the whole ordeal is likely a net positive, and markets are likely too skeptical.
In terms of portfolio adjustments, we will sell down TSM to 0%. While TSM remains a dominant business in its industry, demand for leading edge chips remain challenged due to tepid smartphone demand in now a fairly mature market. After we added TSM in mid-2022, we have further increased our weights in AMD as well as added Marvell. Semiconductor stocks have been strong since late 2022, supercharged by ChatGPT mania. I think it makes sense to continue to manage semi exposure, much like what we have already been doing by trimming Nvidia over the last several months. The whale wants to go one way, but it’s probably best to think a little further ahead. Selling TSM would help us do that.
Another somewhat significant adjustment will be our reduction of TPL. We bought TPL as an inflation/oil/commodity hedge at the end of May. That turned out to be a very timely and appropriate decision since oil effectively bottomed at that time and staged a rally to $95 over the last few months. That drove TPL up over 40% in 3 months. Since TPL is meant to be a hedge, it makes sense to now reallocate some of that capital after the run.
Alright, let’s see what October brings.
Onward.
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Disclosures: Of the stocks mentioned, I own shares in PINS, KIND, NET, SE, MRNA, U, OKTA, SDGR, SNAP, ENVX, ZI. I have no intention to transact in any shares mentioned in the next 48 hours.
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