Jarvis™ Newsletter: Taking Advantage Of Market Volatility With End Of Year Strategies

Summary

• What’s Happening?
• An Update on an Old Favorite Stock.
• Energy Discussion, Examining Movement of Bonds vs. Stocks of Same Company.
• Bond Strategy: Short Duration High Yield.
• S&P 500 vs CLOU: Analysis and some suggested stock swaps for year-end.

-Brian Dress, CFA, Director of Research, Investment Advisor

Overview

Volatility continues to be the order of the day and this week has been no exception. However, the direction of the volatility appears to be shifting, with growth stocks regaining some momentum after last Friday’s sharp sell-off. As investors, we do not particularly enjoy these bouts of volatility, but they do create opportunities for us to make shrewd portfolio moves that can help us to optimize taxes and set us up for a prosperous 2022.

In this week’s letter, we will give some recap of the last week’s action. Beyond the day-to-day gyrations, we will focus squarely on more end-of-the-year strategies that investors can implement to deal with taxes, as well as another strategy to help income-oriented investors cope with persistently low interest rates. We will also look at an energy name and show how the company’s bonds (and stock) reacted to the swift drop in oil prices. Finally, we share with you a couple of changes we think investors should consider in their portfolios to respond to the past week’s news, as well as a shift in market sentiment away from the dominant stocks of 2020.

We also will give you a brief update on a stock that was our favorite pick for 2020, but has languished over the past 6 months. We think the story is instructive of the circuitous path that growth stocks often take during a long-term holding period.

For the five days covered in the report, stock market action has been volatile. In terms of the major averages, the broad-market S&P 500 gained 2.41%, while the tech-heavy NASDAQ Composite advanced 0.88%. The small-cap Russell 2000 grew by 0.93%. A new feature of the Jarvis letter will be the weekly data table, which will give you Thursday close prices and weekly change percentages for selected indexes (see below; covers dates 12/3-12/9).

Index	Close Price	Weekly Return (%)
S&P 500® (US Broad-market Index)	4667.46	+2.41
NASDAQ Composite (Tech+)	15517.37	+0.88
Russell 2000 (Small Company Index)	2226.91	+0.93
Emerging Market Index (EEM)	50.05	+0.87
Oil price (WTI futures)	70.53	+6.81
Bitcoin (BTC)	47649.53	-15.63
iShares Software Sector ETF (IGV)	400.51	-0.88

When markets get squirrely, it can be difficult to determine the best course of action. Should you buy the dip or sell into weakness? Whether you manage your own portfolio or currently work with an investment professional, we are here to help. Fill out our form for a Free Portfolio Review and a member of our Investment Advisory team will contact you to set a meeting. We will give you our views of whether you are properly positioned, given the current market conditions and our outlook for 2022.

If you like what you see in the weekly Jarvis update, please share this newsletter with other investors, friends, and colleagues. The success of the Jarvis newsletter depends on your word-of-mouth recommendation to other like-minded investors. Just in case you are not receiving the newsletter into your inbox on Saturday mornings, make sure to visit our website to get yourself on the mailing list. The Jarvis Newsletter is a great way to get your weekend started, as you use your time with the markets closed to do deeper research and prepare for the next week of investing.

With that all being said, let’s get into it!

What’s Happening?

Note that this week, we’ve removed the 4-letter word from the title of this section, as markets appear to have calmed down just a bit. Though volatility remains a bit elevated above the benign levels we have become accustomed to seeing, cooler heads are beginning to prevail, as opportunistic buyers step in to scoop up quality stocks at reduced prices.

General Growth Stock Update

Last Friday, the selling was indiscriminate and violent. The Relative Strength Index (RSI) measures whether a stock/index is overbought or oversold at any given point in time. In the chart below provided from TradingView, we chart the iShares Expanded Tech-Software Sector ETF (IGV) with its RSI at the bottom of the chart. As we can see, the ETF traded sharply lower last week and the RSI touched 30, suggesting an “oversold” condition. Considering that this ETF holds a substantial segment of assets in mega-cap tech stocks like Microsoft (MSFT), Salesforce.com (CRM), and Adobe (ADBE), an RSI reading of 30 is remarkably low. The main takeaway from the chart is that this sector ETF tends to make local bottoms when the RSI touches 30 (represented by the dotted line at the bottom of the purple area in the chart). That appears to be the case again this week. The “buy the dip” brigade appears to have returned in force to growth stocks and rapid snap back higher in IGV is good evidence of that notion.

Check-in on an Old Favorite: ROKU

ROKU was Left Brain’s stock pick of the year for 2020 and it is a business that we have followed closely over the past three years. We also talked about the company on one of our most recent podcasts, as long-term investors have been inquiring how best to approach their positions in Roku. As you can see from the 2-year chart below (source: TradingView), the stock was one of the best performers in 2020 and the beginning of 2021, only to tail off sharply over the last six months, amid concerns about competition from Amazon and Google, along with a premium valuation.

At the end of last week, Roku’s Relative Strength Index fell as low as 20, which indicates an extremely oversold stock. Many investors have abandoned the name, taking profits on multi-bagger gains or booking losses for tax (and other) reasons.

We have an update on the business conditions at Roku that appears to have shifted sentiment, which was clearly quite negative over the past six months. For most of 2021, Roku has been embroiled in negotiations with Alphabet (GOOGL) over whether the latter would allow its YouTube channel and YouTube TV streaming service to remain on Roku’s platform.

On Wednesday this week, we saw an end to the impasse. Roku and Alphabet announced a multi-year deal for the YouTube channel and YouTube TV streaming service to remain fixtures on the Roku platform. This alleviates some of the concerns investors have had that competitive pressures would weigh on Roku shares in the near-term. We take the news quite positively, as it shows that Roku continues to have bargaining power with content providers. One of the strongest arguments for Roku is that its platform is provider-agnostic, offering users access to most of the streaming platforms that are available to viewers.

There seemed to be broad agreement that this news was positive for Roku shares, with the stock trading as much as 20% higher on Wednesday. We also saw a series of upgrades from analysts that cover Roku.

For those investors still holding large gains in Roku, recent strength might be a chance to reduce highly concentrated exposures. We will speak more on this topic in the section of the letter where we cover stock swaps. With that said, we think this news clears the field for ROKU shares to move higher in the near-to-medium term. We remain believers in Roku’s business case, above all other considerations.

Risks: Competition, High Valuation, Streaming viewers may reduce their hours watched if/when pandemic concerns ease and more people return to leisure outside the home.

Energy: Balloon Slowly Deflating, Opportunity Still Available

Energy has been one of the best performing sectors this year, with oil and gas prices rebounding strongly, after oil traded negative in early 2020. Over the past month, momentum in energy prices has reversed and crude oil and natural gas have fallen sharply. As you can see in the chart below (source: TradingView), the price of natural gas (in orange) has dropped aggressively.

We have two observations to share with you about energy:

1. Oil might be falling, but this is not translating directly into poor performance for the largest oil companies, like ExxonMobil (XOM) and Chevron (CVX). As we can see in the following chart (source: TradingView), XOM (orange) and CVX (light blue) have fared much better than has the actual price of oil (dark blue).

We think there is good reason for this. Breakeven prices for oil production (at least in the US) are well below $60/barrel and in many cases lower than $50/bbl. This means that even as crude oil prices dip into the high-$60s and low-$70s, the large producers should remain profitable. There has also been ample time with prices far in excess of breakeven, which has allowed these large integrated producers to book significant profits and also hedge future production at attractive prices, locking in predictable cash flows for future quarters.

We continue to think energy stocks are under-owned among many investors, as we wrote about in the October 8 newsletter entitled “Energy: More Room to Run?” . As a result, we think adding exposure to energy is a prudent move, especially for growth investors looking for a way to diversify some of their funds away from heavy concentrations in technology investments. These conditions we mention above mean that we favor investments in the large integrated players like XOM and CVX as ways to increase exposure to energy stocks.

2. There may be a better way for investors to play energy beyond the usual stock exposures. We wanted to illustrate the point here by taking a look at both the stock and the bonds of Callon Petroleum (CPE), a relatively small exploration and production (E&P) firm based in Houston. These are our observations of how the two securities performed over the last month, as oil prices dropped.

Rather than explain in words, we think the chart will give you a better indication of the point. Take a look at the 1-month chart below (Source: FactSet). In blue, you will see the performance of the Callon 2026 bonds (in blue), charted against the stock performance (in green) and the price of WTI crude oil (in purple). The clear takeaway here is that the price move in the bond was very muted, when plotted in relation to the moves made by crude oil and the stock itself.

As we pull back at the year-to-date chart (below), we can see that a similar pattern emerges. Callon stock has advanced by more than 300% in 2021, compared to a 50% increase in crude oil prices and a nearly 90% run in the 2026 bonds.

All of this is to say that we think investors looking for energy exposure should consider all options. More risk averse investors can take positions in the bonds of a given oil company and expect less volatility than they would experience if invested in the corresponding stock. At Left Brain, we always start with our research by looking at the business case. When we like a business, we then drill down and determine the best way to take on exposure, whether it be through equity (stock) or debt (bonds). Depending on your preferences and your circumstances, one may be more appropriate than the other!

Portfolio Corner: Fixed Income Alternative Strategy, More Tax Talk

Short-dated High Yield Bonds

We have spent plenty of digital ink speaking about how income-oriented investors can generate yield in a world of low interest rates. For new readers, the gist of it is something we all probably can sense intuitively. With Central Banks around the world still in a stimulative policy position, rates of return on fixed income instruments across the board are quite low. This is true whether we are speaking of government or corporate bonds, money markets, or any other asset in the category.

In past editions of the Jarvis newsletter, we have spoken of a number of strategies you could pursue to find additional yield, whether it be to pick into high yield corporate bonds, municipal bonds with non-taxable coupon income, or purchasing “bond-like equities” like dividend-paying stocks or Real Estate Investment Trusts (REITs).

This week we have yet another possibility for you to consider: purchasing short-maturity high yield bonds. The concept is predicated on the idea that interest rates are likely to be higher two years from today than current levels.

Reinvestment risk is the idea that when a bond matures, one has to reinvest the funds paid at maturity into another instrument. If interest rates are lower at the time of maturity relative to when the investor purchased the bond, then there is no suitable replacement that will generate a similar income for an equivalent level of risk. With the following strategy, we look to turn the concept of reinvestment risk on its head, by allocating funds into a bond that matures in 2023, when interest rates have a good chance to be higher than they are today.

If we purchase high yield bonds that mature in 2 years (or less), we think there is a good chance that we may be able to take the proceeds from these purchases and buy either (1) higher yielding bonds in the future or (2) bonds with similar yields that have lower risk profiles. Either outcome would be attractive relative to the current menu of fixed income opportunities.

There is one such bond that we would give you as an example: Calumet Specialty Products (CLMT) 7.75% 2023 bonds. These bonds mature in April 2023, allowing you to collect roughly 7.7% annualized income (at current prices) for the next 16 months.

We have followed CLMT for some time. Calumet produces a series of refined oil products, including waxes, lubricants, and oils, which are used in aftermarket automotive applications. The company also has a business interest in a refinery in Montana, which is engaged in the production of renewable diesel.

There has been revenue growth in the business, driven by increased margins in the company’s specialty products division ($67.60 in profit margin per barrel of oil refined in 3^rd quarter 2021 versus $57.79/barrel in the previous quarter). So fundamentally, there is progress here. But what really gets us excited as bond investors is always the word “deleveraging”. In November of this year, Calumet announced a strategic transaction, funded through a $300 million investment from Oaktree Investments. This will separate the renewable division from the specialty products division. This resulted in Calumet receiving nearly $200 million in cash, some of which was deployed to retire the $80 million in outstanding 2022 bonds.

We think these bonds are very likely to be repaid in 2023, at which case investors may be able to find a higher yielding investment, should overall interest rates rise.

Risks: Calumet uses crude oil as its main input, so oil price rises could weigh on margins. The company has significant debt, so there is default risk here.

Software Weakness Means a Chance to Realize Losses, Change Positioning

Software/technology/cloud computing were some of the most dominant themes in the stock market in 2020 and into February 2021. We observed a peak in this class of stocks on February 9, 2021, a recovery beginning in mid-May, and another short-term top on November 9. Review the chart below. You will notice that cloud computing stocks (blue line), as represented by the Global X Cloud Computing ETF Global X Cloud Computing ETF (CLOU), have significantly underperformed the broader market, signified by the S&P 500 (orange line).

The net result of this phenomenon is that quite a few stocks in this class are showing a loss for the year. Investors who purchased any of these shares in 2021 are likely to be holding an unrealized capital loss in these names. Should you have capital gains for the 2021 tax year, there is an opportunity here potentially for tax-loss selling in many of the stocks in the table below. One option is to buy these stocks back 31 or more days after you initially sell them, as we detailed in our November 19 newsletter. This allows you to be compliant with the “wash sale rule” and take full tax advantage of realizing your capital losses.

Ticker	Name	12/8 Close price ($)	Change Since 11/9	Change in 2021
ATVI	Activision Blizzard, Inc.	59.27	-11.67%	-36.17%
CHGG	Chegg, Inc.	28.71	-4.46%	-68.22%
CHWY	Chewy, Inc.	60.1	-21.56%	-33.14%
CRWD	CrowdStrike Holdings, Inc.	209.18	-28.65%	-1.25%
DOCU	DocuSign, Inc.	153.74	-44.13%	-30.84%
MELI	MercadoLibre, Inc.	1210.4	-29.22%	-27.75%
OKTA	Okta, Inc.	240.07	-10.52%	-5.58%
PYPL	PayPal Holdings, Inc.	197.35	-3.93%	-15.73%
PTON	Peloton Interactive, Inc.	45.91	-8.42%	-69.74%
ROKU	Roku, Inc.	256.08	-8.47%	-22.87%
SPLK	Splunk Inc.	119.43	-31.09%	-29.70%
TCEHY	Tencent Holdings Limited	60.34	1.31%	-17.04%
ZM	Zoom Video, Inc.	194.86	-24.59%	-42.23%

Alternatively, we think there is some argument for diversifying some funds out of this sector (at least temporarily) particularly if you hold a concentrated allocation. Though we are not making this call definitively, there is some risk that the market will continue to punish hypergrowth stocks with negative profitability, given concerns around inflation and interest rates. Examples of replacement allocations include megacap tech (AAPL, GOOGL, FB, MSFT), energy (XOM, XLE), or retail/consumer discretionary (TGT, XLY).

For additional color on end-of-year positioning and strategy, my colleague, Freddy Garcia, spoke on the Left Brain Thinking Podcast this week. Rebalancing has been the topic of interest in the office over the past few weeks, so we think you will gain some great insight from Freddy’s appearance. And if you like the podcast, don’t forget to click 5-stars and leave a review. It helps the podcast be found by other like-minded investors!

Takeaways from this Week

We saw continued volatility in growth stocks this week, but this time mainly to the upside, as many of the oversold stocks from last week reversed violently, especially on Tuesday. We know, as growth investors, that part of the price for above-market returns over the long-term is short-term volatility. The last two weeks have been a good illustration of this observation. As we saw on Wednesday with the ROKU news, reversals can be swift in this segment of the stock market.

After a very strong first 11 months of 2021, we have begun to see signs of slight deflation in the oil/gas markets. With that being said, we have discussed in previous iterations of this newsletter that many market participants remain underweight the sector. Particularly for investors looking for a way to diversify somewhat away from concentrated tech exposures, we think there is still a great opportunity to invest in energy. Our favorite ways to do so include XOM and XLE. For more income-oriented investors, there are still great opportunities in the bond markets to participate and lock in attractive yields.

We spoke briefly about the fact that when selling in a specific sector happens, that bonds often hold up well compared to the stocks of the corresponding company. This is important insight for investors that want to control the risk levels of their portfolios. We also proposed a strategy for generating income through short-dated high yield bonds that could potentially set the table for you to take advantage of better opportunities in the bond markets in a couple years, should interest rates rise.

Finally, we finished out the letter with yet another strategy for investors to deploy in anticipation of the end of the year and optimizing taxes. While some of the more hypergrowth stocks have disappointed in their performance in 2021, the time is now to use the negative sentiment to our advantage to offset other realized capital gains.

Thanks again for your continued support of Left Brain and the Jarvis newsletter. Again, if you found value here, we would humbly ask that you pass the newsletter along to friends or colleagues with interest in investment strategy. Make sure you sign up to receive the newsletter weekly in your inbox, if you haven’t already. Have a great weekend!

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