Here in Florida we like to refer to our 3 seasons as Summer, Summer and More Summer. Well, as Summer comes to a close, we have a ton to be thankful for. Number one, over the last few days COVID deaths and hospitalizations have declined– hopefully this trend continues. Also, this upcoming weekend is Labor Day. This brings to mind how, this year more than ever, we need to honor our workers, especially our first responders and our military. Labor Day also brings the start of football season, particularly college football. Here in Florida ,that also brings us to the start of our last season of the year, More Summer. This year, we will finally see people back in the stands. However, change may be in the future with the NCAA changing their rules regarding athlete compensation. You may have seen the term NIL, which stands for “name, image, and likeness.” Rule changes will allow college athletes at every level to monetize their success with the use of their name, image and likeness. While changes are needed, I’m cautious how this will impact the locker room and the team when one player might be paid a million dollars a year while the rest of the team makes nothing! And to boot, some players have mentioned wanting to be paid in cryptocurrency. Stay tuned to see how this works out and more about new risks around the latter in the newsletter.
Honoring our first responders and our military hits home even more this year, as we have just vacated Afghanistan after a 20-year war. On top of this, we are now approaching the 20th anniversary of 9/11. Most of us will never forget that day, and it remains probably the most significant memory of our nation’s history in my personal life. We all have friends or family that were personally involved, and it was profound how we came together as one united country, with is something I think we need today more than ever before. As you are enjoying your Labor Day weekend, take time to reflect on the meaning of Labor Day and specifically the lives lost and the heroism of our first responders, military and our veterans that have sacrificed so much for us for our country’s freedom. There is no way that we can ever pay them back, and we all should know by now that freedom isn’t free. So, take the time to thank first responders and military members for their service. Have a safe and free Labor Day. God bless you, and God Bless America.
Three Market Indicators
Here at 401karat, we focus on three market drivers that lead to notable movements in the stock market: market economic fundamentals, technical environment, and investor sentiment.
Our fundamental indicator follows 19 points economic datapoints that track the underlying health of the US economy. From unemployment to homebuilding, changes in these economic datapoints tend to confirm recession or recovery after the technical and sentiment indicators have already reversed.
Dynamic Asset Level Investing, or D.A.L.I., is a technical indicator that compares each of the major asset classes, sectors, and sizes and styles against each other to discover emerging trends in the market. D.A.L.I. compares daily price action of each of these elements on a point-and-figure chart to illustrate momentum. The chart at the bottom of this page shows the current leadership in D.A.L.I.
Our sentiment indicator tracks how everyday investors currently feel towards the US economy and the stock market. Between 401karat’s own polling and professional surveys like the American Association of Individual Investors (AAII) Investment Sentiment Survey and Citigroup’s Panic/Euphoria Model, 401karat tracks the two most dangerous emotions for investors: fear and greed.
Here is a breakdown of where each market driver currently sits:
Second quarter GDP came in at 6.6%, higher than analysts’ expectations.
The S&P 500 remains third out of 135 asset classes in our relative strength rankings. However, niche areas of the market like large and mid caps and growth stocks have shown some improvements in the near-term.
The AAII Investor Sentiment Survey reported over 39% of investors as feeling bullish, a level higher than the historic average and the highest level since the beginning of July.
Active vs Passive: When to Pay
Before we get into the breakdown, first we need to understand the difference between active and passive funds. An active fund refers to a fund in which there is a manager that chooses the underlying investments inside of it; in short, the manager is handpicking the holdings of the fund based off their own analysis and research. In contrast, a passive fund is an investment that is meant to directly match an index, such as the S&P 500 or the Dow Jones Industrial Average. Passive indices utilize a momentum strategy in their own way, as companies fall out of the index and are replaced by new up-and-coming companies; a recent example of this is when Tesla was added to the S&P 500 at the end of 2020.“You can’t beat the index.” Nowadays, you’ll be lucky to find someone who won’t simply recommend a low-cost index fund as their preferred investment choice, and who can blame them? With investors increasingly more conscientious of fees and managers struggling the keep pace with the S&P 500 as of late, the choice between active and passive management seems simple and decisive. However, we’d like to break down if there are certain areas of the market that require active management, and if so, which areas in particular.
Now that we understand the difference between active and passive management, it’s time to address the elephant in the room: is there ever a justified reason to have active management? At the top of this page, you will see a comparison of two asset classes to their respective indices: small cap growth and large cap value. In the tables, you will notice that the top small cap growth managers regularly and significantly outperform both of their indices even with fees, while the top large cap value managers simply keep pace with their indices. Part of the reason that small cap growth managers outperform is that managers can more easily focus on the top performers, as not every small cap company breaks out and becomes a mid cap or large cap company. In contrast, large value companies are staples of our economy, which makes differentiation more difficult for a manager. In short, specific asset classes historically benefit greatly from active management, notably outpacing their respective indices even with the increased costs.
While we have focused on equities, bonds also benefit from active management. For equities, a cap-weighted index like the S&P 500 rewards larger companies; the larger a company’s market cap, the larger the weight in the index. On the flip side, a bond index gives the companies issuing the most debt the largest weights in the index. With this overweight to the companies with the largest debt leverage, bond indices tend to increase their risk exposure over time. However, an active bond manager can pick and choose the quality of the bonds that they wish to include in their fund in an attempt to reduce any significant exposure risks.
While there are absolutely instances in which it is better to own a low-cost index fund, there are certain asset classes in the market that benefit greatly from active management, including small cap growth and fixed income. Now that we are aware of these instances in which active management more than pays for itself with outperformance or risk mitigation, remember this the next time you base your investment decisions solely off of expense ratios.
Crypto: At a Regulatory Crossroads
Chances are you’ve had a better week than Coinbase. Yesterday, Coinbase’s security system sent a message to over 125,000 users that their two-factor authentication had changed, only a week after CNBC ran a piece detailing Coinbase’s ineffective responses to users’ accounts being hacked. One couple mentioned in the article shared how they had their Coinbase account of nearly $170,000 in cryptocurrency drained overnight by a hacker. Another user shared how, after having his account hacked, Coinbase replied to his concerned email by saying that, “… Coinbase is unable to reimburse you for your alleged losses.” While crypto enthusiasts tout the unregulated aspects of crypto as a positive, these examples highlight the flip side of that coin: the lack of user protection.
Major broker dealers and other financial institutions carry a federally mandated form of insurance known as SIPC. By being a member of SIPC, these institutions ensure that their customers have their securities and cash insured for up to $500,000. If that previously mentioned couple had been invested in traditional securities and held those funds on an insured platform, they would have been reimbursed for the full $170,000. In contrast, cryptocurrency’s unregulated market means that it is truly a free-for-all regarding account hacking. In fact, the problem has been so pronounced that over 11,000 complaints have been filed by Coinbase users with the Federal Trade Commission and Consumer Financial Protection Bureau.
This lack of protection isn’t limited to Coinbase, however. Robinhood is an SIPC member for its normal investment accounts, no different than other major investment platforms. However, cryptocurrency investments held at Robinhood have no protection, as Robinhood Crypto is not protected by SIPC. In short, this is how all cryptocurrency platforms operate today, as there is no regulation regarding user protection. While Robinhood and Coinbase are publicly traded companies, they are not immune to this inherent risk in having a crypto account. With the hacking becoming more commonplace as crypto continues to become more mainstream, more and more crypto investors are being faced with the harsh reality of investing in a wholly unregulated market. The ironic aspect of this situation is that the poster child of cryptocurrency is Gen Z, a group that generally is skeptical of Wall Street and losing money in the stock market after seeing their parents experience 2008. However, we don’t believe that their trust in crypto and distrust in traditional investments is hypocritical; rather, it is a lack of understanding about the inherent risks of investing in an unregulated market like cryptocurrency.
Now, the big question: what does this risk mean for the future of cryptocurrency? We believe there are two paths forward, with one significantly more likely. The first path is that the unregulated market cannibalizes itself through hacking and shady dealings, becoming what famous investor John Paulson refers to as a “limited supply of nothing.” On the flip side, the most likely scenario is that regulatory oversight is established; while this would defeat one of the initial purposes of cryptocurrency, it would provide some semblance of a safety net for crypto investors. In fact, the new SEC chairman, Gary Gensler, taught a course on cryptocurrency at MIT before accepting this position, meaning that the SEC has new insight into this area of the market. In short, if the hacking of crypto accounts continues to accelerate and users continue to file complaints, regulatory provisions may be enacted sooner than later.
Chairvolotti Financial, Inc. dba 401karat is a Registered Investment Advisor