Financial Markets Review

Beginning in July and spilling over into the first few days of August, a notable sea change has taken place throughout financial markets. We have talked and written ad nauseum about the dominance of the Magnificent 7 over the past 18 months. And how a handful of the largest companies have been responsible for the bulk of the gains in the S&P 500 and Nasdaq. That narrative began to reverse in mid-July just as the dispersion between the market cap weighted S&P 500 and the equal-weighted S&P 500 hit levels last seen at the height of the Tech Bubble. For the month, major market indices were generally higher with the market-cap weighted S&P 500 closing higher by 1.1%. However, the reversal from big cap tech and growth to everything else showed up prominently in the equal-weight S&P 500 and small-cap Russell 2000 advancing 4.5% and 10.1%, respectively.

The rotation out of growth has picked up steam over the first few days of August leading to a surge in volatility, which has put pressure on the major indices. However, none of this should come as too much of a surprise. When the overwhelming majority of investors are positioned the same way or participating in the same trade, it doesn’t take much for the market to go in the other direction. In mid-July, it was reported that for the 16th straight month, the most-crowded trade remained long the Magnificent 7. At the same time, the Investor’s Intelligence survey showed bulls increased to 64.2%, while bears fell to 14.9%. The vast spread between bulls and bears was one of the highest on record and similar to what we saw in January 2018, right before a period known as Volmageddon, when volatility surged and equities sold off sharply.

It’s been a while since I’ve shared the following quote from Seth Klarman, but I think it sums up where we have been in the market over the past couple of months.

“When share prices are low, as they were in the fall of 2008 into early 2009, actual risk is usually quite muted while perception of risk is very high. By contrast, when securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.” – Seth Klarman, Founder, CEO, and Portfolio Manager of Baupost Group

Specifically, amongst large cap growth stocks, there has been a mismatch between perceived and actual risk building for quite some time. In fact, one could probably make an argument that risk was perceived to be highest in everything non-AI related and lowest in AI related companies, whereas we are now witnessing that the reverse was actually true. Actual risk is highest in the companies that have gone up the most and are priced to perfection, while actual risk is fairly low in everything else that has just muddled along for many months now. And this is why you are seeing the recent weakness hit the large cap growth stocks the hardest, while the vast majority of companies hold up fairly well amidst the heightened volatility.

We never quite know what the catalyst will be that ends up setting off weakness in equity prices, except that it doesn’t take a lot when everyone is on the same side of the boat. Today the risks span from geopolitical tensions to uncertainty surrounding the upcoming U.S. Presidential election and most recently the unwind of the Japanese Yen carry trade. All these risks are playing a factor in the current weakness with the Yen carry trade being the biggest culprit in the short term. However, the greatest risk of all seems to be one that we’ve highlighted for a few months now, and that is the slowing of the U.S. economy. It is still too early to tell if we are headed down the path of a recession, but between the weakening of the labor market and countless companies reporting of a struggling consumer, it’s a risk worth keeping at the front of mind.

Tandem Strategy Update*

As we head into a period of the year that is known for negative seasonal effects on equities, coupled with the numerous uncertainties both domestically and abroad, there is no doubt that volatility is here to stay for the foreseeable future. It’s in times like these that it is imperative to adhere to a disciplined process that removes emotion from your decision-making process. This is also a good time to make sure your investment strategy aligns with your risk tolerance.

Over the past month, our process has led us to make a few adjustments within our strategies. On the basis of valuation, we trimmed our positions in Republic Services (RSG) across all strategies and Intuitive Surgical (ISRG) within our Equity strategy. Both companies continue to show impressive growth; however, our quantitative model signaled an unsustainable valuation, which calls for us to risk manage the positions by scaling back our allocation to these companies.

In addition to the valuation trims, we’ve made a few sales for companies that no longer meet our criteria of consistent fundamental growth. We have wrapped up the liquidation of SEI Investments Company (SEIC), as the company was not able to pass through the fundamental screener of our quantitative model. SEIC’s inability to produce consistent revenue, earnings and cash flow growth over the past few years has forced us to liquidate the position across all strategies.

By now, it’s no secret that consumer facing companies have struggled for the better part of the past year. Unfortunately, Nike (NKE) was not spared from a combination of a weakening consumer, fashion missteps and a management team struggling to adapt. After the company’s most recent earnings call, NKE also solidified their inability to consistently grow earnings and cash flow over the past couple of years and for the near future. Over the past couple of weeks, we have begun the process of unwinding our position in NKE, which will be liquidated from our Large Cap Core strategy in time.

Lastly, we nearly wrapped up the liquidation of Check Point Software Technologies (CHKP) within our Equity and Mid Cap Core strategies for failing to consistently hire management from within the company. One of our requirements for a company is to show depth in the management team and the ability and willingness to hire from within. Early this year, CHKP announced their founder was stepping down from the CEO role. After an extensive search, the company decided to hire the next CEO from the outside. This decision, coupled with the hiring of several other executives from the outside in recent years, has caused CHKP to violate our requirement of consistency in management.

Given the recent spate of volatility, I suspect there will be plenty of opportunities in the ensuing months to add to existing holdings, initiate new positions and pare back our allocation to companies that are either overvalued or no longer meet our fundamental criteria. Regardless of the opportunities presented to us, every move we make within the strategies will be dictated by our emotionless, disciplined process.

*The transition level activity taken by Tandem is applicable to new accounts and new money, not the composite or firm-wide level. New accounts and new money are not automatically invested on the first day. Rather, they are transitioned into our strategy over a longer time period that is dependent upon market conditions. Strategy level activity is applicable to the composite and action is taken at the firm-wide level.

Source: Source of all data is FactSet, unless otherwise noted.

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Disclaimer: Tandem Investment Advisors, Inc. is an SEC registered investment advisor.

This audio/writing is for informational purposes only and shall not constitute or be considered financial, tax or investment advice, or an offer to sell, or a solicitation of an offer to buy any product, service, or security. Tandem Investment Advisors, Inc. does not represent that the securities, products, or services discussed in this writing are suitable for any particular investor. Indices are unmanaged and not available for direct investment. Please consult your financial advisor before making any investment decisions. Past performance is no guarantee of future results. All past portfolio purchases and sales are available upon request.

All performance figures, data points, charts and graphs contained in this report are derived from publicly available sources believed to be reliable. Tandem makes no representation as to the accuracy of these numbers, nor should they be construed as any representation of past or future performance.​