During our last correspondence we discussed our team’s outlook on the market coming into the summer months. The portfolio consisted of a 30% cash position and our plan to deploy that cash was predetermined based on market movements during much of June. We discussed three different possibilities back in late May, one of which included the melt-up we saw on the backs of ever-improving economic data and continued monetary stimulus. With a current cash position of about 4%, we consider ourselves to be fully invested, and have been fully invested since late June. Despite COVID cases increasing throughout much of the summer, we believed Wall Street would pivot to economic recovery data over virus case numbers when determining the market’s path.
The mix of exponential virus growth and a roaring market made us believe that tracking virus cases and hospitalizations were not the most important thing to analyze when constructing the portfolio. Rather, the response to the virus became the most important thing to track in the various hotspots. We saw that hotspot economies slowed but did not shut down completely. Instead, we saw states remained largely open for business, but with stricter policies that can allow for the respective economies to stay open as compared to closures seen this past spring. The idea that this will be the strategy going forward, mixed with increasingly better news on a vaccine and treatment, makes us believe relatively low volatility can coexist with the virus. In addition, the likely continuation of federal stimulus and Fed policies will build a bridge into a post-pandemic world for equity prices.
As discussed during our last dialogue, we raised cash early-on in the COVID crisis as data started to come in from the various private companies Tony owns out of his family office. This data gave us ahead start on the market and our Q1 returns showed that. We took our head start on the market recovery as an opportunity to preserve capital in the event the economy dipped to a shutdown induced depression. Considering we did not see such an outcome; we began deploying capital steadily until the portfolio became fully invested. So long as the market proves to be stable, we will continue on our current path.
However, we cannot ignore the valuations of today’s market. As we started to rebuild our portfolio in the midst of the crisis, we didn’t give much consideration to valuations due to unknown earnings. Instead we tailored the portfolio in large part around companies that would perform during the crisis. This led us to an overweight portfolio in large cap technology. Now that there have been two quarter’s worth of earnings and guidance from these companies, we can better understand their valuations. While valuations do indeed look high, we believe this will be cause for a plateau in stock prices more so than a sell-off so long as the virus is a threat to the economy. Keep in mind, these are some of the only companies in the world that are built for a pandemic.
That is not to say we won’t see a rotation into value or quality over the coming months. In fact, that would likely be an area where we can invest further as the market plateaus. As we have done the past several months, we will sell covered calls against all positions that are at or near all-time highs. When doing so, we look to capture an additional 1.5% return per month on each position by selling out-of-the-money covered calls on a weekly basis. Where we will not be selling calls is on positions that still have room for recovery before hitting their pre-COVID highs. Selling calls consistently against the portfolio’s all-time high positions will ensure that there is still yield being earned on names that seemed to have peaked. Not selling calls on names that haven’t hit their pre-COVID peak will ensure we do not miss those parts of the recovery.
The CEA team is forecasting that the S&P 500 will remain relatively flat to slightly positive throughout the remainder of the calendar year barring a vaccine approval. We believe that there is enough of a financial bridge being provided by the federal government and the Fed, giving the market enough confidence to avoid another threat of extreme volatility. Moreover, we do believe a range-bound scenario for the market is the likely case given a federal financial lifeline of stimulus to the economy is no reason for the market to continue surpassing pre-COVID highs by a large degree.
This largely flat market climate is one that is ideal for harvesting premium. The CEA team will continue selling covered calls and deploying put spreads to earn a large portion of this year’s yield.The premium exposure in the event the market finds a ceiling somewhere near its current price level will only help should the market plateau.
The election is a calendar event fast approaching that we cannot ignore. With so many potential outcomes, it’s nearly impossible to position the portfolio based on our team’s bets on what could happen. Additionally, the possibility of not knowing who will be President on election night only adds to the uncertainty. This of course will likely result in volatility leading up to the election and until we do know who the President will be.
During events like an election, it is very common that we decide to raise cash and utilize hedged premium positions in place of what was larger long equity positioning. This allows for us to participate in the immediate market actions following these events to some degree, but without the entire risk associated with these events.
To conclude, we want to give you insight as to where the portfolio sits today. As of the time writing this letter, the fund is up approximately 11.5% for the year compared to the S&P 500 being up 8% YTD. The portfolio remains largely invested in a mixture low-beta recession proof companies, along with high-beta growth technology. All investments must fit our “COVID narrative” in that they are poised to either benefit from a pandemic or are positioned to capture market share post-pandemic. An example that fits the “COVID narrative” would be KMX. Due to many people fleeing dense urban environments, we have seen a shift to intense auto sales.
Another example is PYPL, which has been the best performer in the S&P 500 YTD.
With the pandemic forcing businesses to adopt digital platforms, we have seen explosive growth in the payments space. Specifically, PYPL is positioned to not only take advantage of a pandemic environment, but a more-digital world post pandemic. PYPL was one of our early pandemic investments that has paid off and was our largest position until we trimmed a few weeks ago. Additionally, we have allocated large investments to retail names such as LOW, HD, and TGT due to the “COVID narrative.” LOW and HD have never seen stronger quarters than their most recent as people renovate the space they are spending more time in: their homes. The PRO businesses of HD and LOW have also boomed as contractors are seeing the best market they have ever seen with housing starts at decade highs. Moreover, TGT is a name that fits the narrative because they built a delivery and pickup platform that suited the COVID environment just before the country shut down. In fact, many of the costs associated with developing TGT’s omni-channel platform were absorbed in 2018 and 2019, setting up 2020 to be a home run year of not only implementation, but explosive demand for said services in a pandemic. Additionally, TGT is poised to capitalize on a post-pandemic world. When governments closed the economy, many small businesses were deemed unessential and forced to close while TGT was designated essential. The consequence was many small businesses closed forever while TGT gobbled up the market share leftover. This was seen in online order-pickup numbers surging by 700%YoY.
The CEA team cannot extend our appreciation enough for having the confidence in us to manage your money.