Investor Appetite: Hungry

As you all might recall from this post, the Rate of Return team was out of office all last week attending the VidCon conference in Anaheim, California.

We’re still getting back up to speed — but I think you all are long overdue a deep dive update on the macroeconomic environment, stock prices, and how I’m thinking about things at the moment.

Big News

We’ve listened to your feedback about these hiatuses and have hired someone to help us stay on track. With this new hire, we’re hoping to get back to posting 4+ times per week —

• The Investing Week Ahead

• Social Media Spotlight

• Top Stock Ideas / Macro Update

• Week in Review

As you all might already know, we’re a two man team doing our absolute best to keep you all updated across all mediums — TikTok, Substack, LinkedIn, Public.com, etc.

We’re confident by adding someone to the mix here, we’ll be able to do that even better. Thank you again for your continued support.

Buckle In, This Will Be a Long One

Let’s rewind for a moment.

The Market is Melting

On December 3rd, 2021 I shared a post titled “The Market is Melting” where I explained how I believe people should be investing their money.

This post outlined why I invest, how I invest specifically for the long-term, other ways I’m building wealth, and how I planned to restructure my portfolio heading into 2022.

Near the end of this post I shared my intention for being extremely strict with new capital invested — allocating it in such a fashion that over the next 3-8 years I’ll be able to generate substantial alpha while protecting my downside risk in a much more reasonable fashion.

Please Be Patient..

After the market fell -10% from it’s all-time-high on January 3rd, I shared a post on February 25th, 2022 titled “Please Be Patient..” where I explained why I believed the volatility was only getting started.

This post specifically outlined where I thought we were in the “boom and bust” phase of our Covid-induced bubble. I shared valuation multiples, image overlays of past bubble “pops,” and that I had opened a position in Berkshire Hathaway (BRK.B) because I believed the second half of the year the market would begin to assign more value to fundamentals and free cash flowing businesses.

I also shared this statement:

And that’s exactly what I’ve been doing — on the sidelines stacking cash.

How Low Can We Go?

On March 15th, 2022 I shared the post “How Low Can We Go?” after Nasdaq officially entered into a bear market.

The goal of this post was to use historical averages, figures, and valuation multiples to try and predict just how low the markets would trade going forward. We said the Nasdaq would likely trade down another -15% to the 200-week EMA at 11,130 points — we actually traded down to 10,587 just a few weeks ago.

I also said:

Finally, I shared a list of 11 stocks that I believed would be worth keeping an eye on.

Valuation Update: Don’t Fight the Fed

On April 14th, 2022 I shared a post titled “Valuation Update: Don’t Fight the Fed” that served as a summary of what leading economists believed the Federal Reserve was going to do in the coming months.

“If stocks don’t fall, the Fed will need to force them.”

Force them they did. The Nasdaq fell another -20% over the next two months while Jerome Powell rapidly raised interest rates. Banks were also kicking off their Q1 earnings — and things weren’t looking good from a macroeconomic perspective. A lot of whispers about a recession.

I also shared the below image — which I just drew on with purple marker showing what the market has done since originally shared in April.

Who Wants to Be a Millionaire?

On May 12th, 2022 I shared a post titled “Who Wants to Be a Millionaire?” where I walked through exactly what was going on with the markets, why we’ve seen so much volatility year-to-date, and shared the “common themes” I found during Q1 earnings releases — inflation & uncertainty. 

The goal of this post was to encourage folks to not fear the markets during times of volatility, but instead get excited about generational buying opportunities.

To add more color to what I was trying to explain, I said:

The Fed, Bottom Signals, and Timelines

Two weeks later on May 25th, 2022 I shared the post “The Fed, Bottom Signals, and Timelines” that walked through countless data points surrounding historical recessions — their lengths, P/E ratios, drawdowns, etc.

I tried to “predict” where the bottom of this bear market might land — concluding somewhere between 13-14X forward price to earnings, or about 3,200 to 3,300 points for the S&P 500.

During our last broad market sell-off, we hit 3,651.

Regardless of when our next sell-off occurs, I predicted we’d see a total decline of about -31% from late-December all-time-highs — which was just over the -24% median recession sell-off.

I also stated the median multiple for tech stocks was 6.2X forward revenue — showing some intense oversold readings:

• This was -44% below pre-COVID levels in Feb 2020 

• This was -20% below the 5-year average (2015-2019)

• This was -6% below COVID lows in March 2020

Finally, I listed off 13 stocks that were free cash flow positive and worth buying at these prices. Below are their names and their change in stock price since publication:

• Adobe (ADBE) -5%

• Datadog (DDOG) +18%

• Zscaler (ZS) +24%

• Crowdstrike (CRWD) +24%

• Atlassian (TEAM) +18%

• ServiceNow (NOW) +10%

• Veeva (VEEV) +30%

• Dynatrace (DT) +13%

• Autodesk (ADSK) -1%

• Hubspot (HUBS) +2%

• Workday (WDAY) -10%

• Salesforce (CRM) +14%

• Dropbox (BOX) +1%

So, Where Are We Now?

But there’s more to the story than just that. If you rewind to February of 2021, you’ll remember the most speculative stocks were beginning to sell off and ARKK was beginning to see it’s fall from grace.

After selling off -25% in 3 weeks, ARKK was “officially” in bear market territory and the most speculative companies (whose entire business model was “growth at all cost”) were beginning to see the unwelcomed volatility.

All of this was initially catalyzed by the Federal Reserve flirting with +25 basis point rate hikes as inflation was only beginning to rear it’s ugly head. Today, inflation is still running hot, the Federal Reserve will likely raise rates +75 basis points back-to-back, and we’re dealing with both civil and geopolitical unrest.

A Key Observation

When comparing the all-time-high peaks between speculative assets and the indices — we see an interesting theme.

ARKK peak: February 12, 2021

QQQ peak: November 19, 2021

Time gap: 9 months

Total duration since ARKK peak: 17 months

Total duration since Nasdaq peak: 7 months

I guess what I’m trying to get at here is that there’s a clear lag between the tops and bottoms of the most speculative assets and the indices. Some of the most speculative assets (aka SPACs, ARKK, and Chinese tech stocks) are now more than 17 months into their respective bear markets.

As we learned in this post, the median duration of a stock market correction lasts 282 trading days — or about 14 months. From the perspective of the indices, we’re only halfway there. However, from the perspective of speculative assets we’re 3 months past our “finish line.”

Now remember, this is all just historical data — but during the Dot Com Bubble Amazon (a very speculative stock at the time) “peaked” 10 months before the Nasdaq did, and “bottomed” 12 months (53 weeks) before the Nasdaq did.

Throughout that 12 month period of time when the Nasdaq was trying to find its “bottom,” Amazon’s stock traded +221% higher.

Market Cycles

Below are a few images that add some additional color as to where I believe the most speculative assets might be headed — the Wall St. Cheat Sheet and Stan Weinstein’s “Stage Analysis.”

The Wall St. Cheat Sheet is pretty straight forward — as you all remember from this post in February, I had a hunch we were between the “Denial” and “Panic” phases.

ARKK has now traded down another -40% or so since — putting us, in my humble opinion, well into the “Anger” category.

Below is an old illustration I shared in this post. I just drew a thick purple line (so you can see more easily) to illustrate where we are approximately trading today. As explained in that post, timelines have been shifted to account for increased investor involvement.

Finally, Stan Weinstein’s “Stage Analysis” is very useful in identifying accumulation phases and potential market “bottoms.”

I want to be crystal clear here — I cannot predict the future and I’m not claiming to. However, I think it’s unwise to ignore the fact that market participants are beginning to put their money back into speculative assets (such as ARKK — below), something that “usually” happens 12-18 months before the Nasdaq sees a bottom.

I have reason to believe the most speculative assets, like ARKK, have greatly experienced their “Stage 4” declines (having traded all the way down to March 2020 lows) and are beginning to form their respective “Stage 1” bases.

These “bases” take several months to develop — several months during which investors like ourselves can accumulate shares of stock at historically undervalued prices.

To add more color to this theory, truly the most speculative stocks on the market are Chinese tech stocks — ADRs. The Chinese Internet ETF (KWEB) declined more than -80% from its February 2021 peak to March 2022 trough. However, since March 2022 it’s begun to “trade sideways” and form this “Stage 1 base” as shown below.

I also tried to draw a purple line showing illustrating the progress of this “base” and where I believe it’s headed (sideways) in the coming months.

Are We Still Going to See a Recession?

A deteriorating economy is something we’ve only begun to experience. As you all read in this post — there are plenty of reasons to believe a recession is coming our way and will likely continue to rock our portfolios all over the place.

Pricing in a Recession

But as you all might have read, the stock market is “pricing in” an 85% chance of a recession. And by “stock market,” I’m talking about the S&P 500 — an index that fell -23% from its peak in late-December.

-23% off all-time-highs is very different from -75% off all-time-highs — like what ARKK has experienced over the last 17 months. In my humble opinion, ARKK and the most “speculative stocks” have already “priced in” a terrible recession and a slew of rate hikes. Which could mean they’re beginning to form their bottoms.

As you all might have seen, commodity prices traded down last week. This could mean supply chain woes are behind us, Jerome Powell’s rate hikes are working, or demand destruction is actually happening — or all of the above!

Remember, copper is used as a leading indicator to determine the strength of our economy (copper is used in almost every durable good we build, so more demand for copper is a good sign for the economy) — and its price action is throwing red flags.

With this all being said — I’m still expecting the S&P 500 to trade much lower, as well as the Nasdaq. My range of ~3,200 or so for the S&P 500 is still in play — alluding to one or two more big sell offs for the indices.

When will these happen?

I’m not sure. But I wholly believe the S&P 500 is still too expensive from a forward P/E perspective given our macroeconomic environment and the laundry list of things that might send us toward a recession.

You Haven’t Bought Any Stocks since March?

As I explained in this post, the purpose of my active stock portfolio (the one I share with you all) is to generate substantial alpha against the S&P 500 over a 3-8 year time period.

Below is an more detailed explanation I shared in the post:

I told all of you on December 3rd, 2021 that I was going to begin practicing an extremely strict new capital investing strategy — so strict that I decided holding cash was the best bet over the last several months.

So that’s exactly what I’ve done.

And I’m glad I did! I’m glad I didn’t “buy the dip” mid-March before another -30% sell off in some cases. I’ve built my cash position up from about $10K to $50K+ over the last 6 months and am eager to begin buying long-term free cash flowing winners now that the “speculative bear market” is beginning to show signs of a bottom.

Over the next 6-12 months as these long-term winners truly form their “Stage 1” bases (before the Nasdaq has a chance to bottom) I’m pumped to accumulate some of my favorites.

Let’s now identify who is worth betting on, and who isn’t.

Free Cash Flow is Key

Let’s make sure we’re all on the same page here with FCF — specifically as it relates to software companies like the ones I shared above.

These companies spend tens of millions (sometimes hundreds) acquiring new customers. It takes a lot of time (usually 24+ months) for these companies to recoup on these acquisition costs.

Once they’ve recouped on these mountain-high acquisition costs, they’re rolling in it. They have a customer that is extremely sticky and likely won’t churn (DBNRR adds more color to this picture) — that is simply padding their free cash flow margin.

This takes time. In most cases, more than three years.

But once that “convergence” occurs — it’s cash printin’ time.

As the markets moved higher in 2020, anyone and everyone was assigning value to software companies — mainly because of work-from-home trends and the insane growth these companies experienced because of them. Now, we’re experiencing the complete opposite — over the last 17 months we sold off non-FCF software companies into oblivion and they’re trading as if they’ll never turn a profit.

At this stage in the bear market, I really want to focus on companies that are already free cash flow positive.

Below is a list of companies that are free cash flow positive right now, projected to grow revenue in a very healthy manner (25% or greater), and are doing more than $1B in revenue annually.

I’ve also added how much they’ve sold off from their all-time-highs to add perspective in relation to the broader indices.

• Datadog (DDOG) -46%

• Crowdstrike (CRWD) -36%

• Snowflake (SNOW) -62%

• Zscaler (ZS) -55%

• ZoomInfo Technologies (ZI) -52%

• Atlassian (TEAM) -55%

• Veeva (VEEV) -38%

• Paycom (PAYC) -45%

As always, thank you for your continued support. This market has been a wild ride thus far, and it’s only going to continue. I hope to help educate and equip you with the tools and resources to make the most educated decisions with your money.

Disclaimer: This is not financial advice or recommendation for any investment. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.