Hedging exposure in this volatile market

0:25Michael Kramer:Thank you. writing on Seeking Alpha in 2014. So it's been a very long time. It's been a very long time. Even just this year alone, we could say we've seen some things. So imagine what we've seen since 2014. It's very, what's the word I'm looking for? Hard to parse the sign sometimes, but it sometimes starts to make sense. Are you feeling that way at all these days as the market is up and down and stocks are up and down and this one's doing well and this one does have more legs, even though it seemingly completely reached its valuation threshold. Right. What would you say? What lessons have you learned and what are you learning right now?

1:08Well, I mean, the key to the market is to always be trying to learn new things and trying to stay up on the learning curve because the market is always changing around you. And what what's worked in the past doesn't always work in the present. And that's one of the harder things, especially for someone like me who's more data driven when it comes to looking at where the markets may be going. I tend to look at a lot of historical factors, you know, and sometimes those things, they just stop working and they don't always have a good explanation. But I think as an investor, it's kind of also your responsibility at that point to then go out and figure out what is working and understand how those dynamics are driving price action.

1:59And I think the last couple of years have been significantly different than the previous decade. It seems like a lot of things changed after the pandemic. I think a lot of those things, not just in the market, but I think in the world. But the market has changed quite a bit over the last four or five years from what it was maybe when I started writing on Seeking Alpha in 2014.

2:25Michael Kramer:What would you say are the things that are working right now? The things that work right now, for me at least, when it comes to understanding market direction, is understanding implied volatility. Understanding where that is and where it could be going. how mechanically implied volatility moves the market on a daily basis, how understanding where implied volatility is going to be may also move the market in the future. And the interesting thing is that event risk brings out more implied volatility, and when the event passes, implied volatility declines. So there's just a mechanical function that goes on when there's those changes.

3:07Option positioning today is much more dominant in the marketplace than it was five years ago. Understanding where those key market levels are in the options market really do play a heavy hand in terms of where the market is and where it's likely to go. I think a lot of technical analysis now is really just a representation of option market positioning. for anyone that understands how options are sort of playing in and you understand the term gamma and gamma levels and delta positioning. A lot of times when I'm doing my work, I'll see that a key gamma level in the S &P 500, let's say, is 7 ,500.

3:48And lo and behold, you look at the technical chart and that's been serving as a key level of support, let's say. And again, I don't think that's a coincidence, right? I think that's a function of one reflecting the other. And so I think that those two pieces are the two that I've worked the hardest on in understanding better over the last four or five years that I've really started to incorporate more into my macro workflow. In fact, anyone that was a member of my service three or four years ago or five years ago, if they were to come back today, they would see a very different approach to what we did then.

4:26I think liquidity flows matter a lot more today than they did before the pandemic, let's say. Bill issuance today, I think, has a significant impact on markets. The Fed has sort of taken a backseat to the treasury market, where the treasury is just having a lot more impact on fluctuations you're seeing in the market because of those ebbs and flows of settlement dates and the amount of money the Treasury is issuing on a regular basis. Like, you know, the amount of money the government is creating is having an impact on markets. I mean, those are the three drivers I think that matter the most today.

5:06And things like economic data, which are used to be very important, seem to not matter very much in a world where options flows are really dominant and liquidity flows are really dominant because, you know, it's like how many times like after a job report that was weak, have we seen the market rally? And you see people on TV trying to explain that rally. It's like, oh, well, the job report was bad. And so that must mean that that's good because the Fed is going to cut rates. Well, no, a lot of times it's because implied volatility on measures like the VIX one day were at 20 going into the job report because everyone was super nervous about it.

5:49Everyone put hedges on ahead of it. And then once that job data came in, those hedges came off. And so everyone had to buy back the hedges. Implied volatility went down and the market went up. And so that's a really important concept to understand when you're trying to live in this world. It's the same thing like the CPI report. Oh, the CPI report came in hot and everyone's like, oh, and the market's rallying because the market loves hot inflation. You know, it's like silly stuff. But understanding those mechanics, I think, play a really important role in market direction and understanding what's happening.

6:30And I think like that's sort of the world that I'm trying to live in right now, because I think that's the driving force in a lot of things. And even with earnings, you know, companies will report like, here's a great example. NVIDIA reports earnings, you know, this week. And, you know, how many times have we seen NVIDIA crush numbers in the past and the stock goes down? And it's like everyone's like, oh, well, they're not good enough. Well, no, because everyone was betting on it going higher. And all those call premiums that people were paying a lot of money for were paying really high implied volatility level that were had really high implied volatility levels have all now decayed because everyone knows what NVIDIA's earnings are going to be.

7:10So all of those calls that were betting on upside are now losing tremendous value, which is now resulting in them selling it, which is causing hedging flows to unwind, which is pushing the stock down. So, I mean, we see this stuff all the time. And there's like a general, I think, misunderstanding of how important the mechanics are today versus when they've ever been before.

7:34Michael Kramer:And how does that practically or actionably inform how you're moving in the markets or what you're invested in or what you're not invested in? Like in terms of the broad markets that you spoke about in terms of not being catalyzed by these economic reports, how does that inform how you're in the market? And like an NVIDIA story, does that mean you're not in Nvidia because you know that the promise, there's a gap between what's coming and what the promise is? So I can tell you personally how I've done this because, again, I'm a registered investment advisor, so I can't make recommendations or anything like that.

8:10I can tell you what I've done, though. Sure.

8:12Michael Kramer:We do not make recommendations on the show. This is just for our joy. Right. And so I can tell you from what I've done for my own portfolio. So one of the things that I was focusing, I think the last time maybe we did this show a year ago, I was suggesting that maybe like life after the Mag 7. I don't know if you remember that. And I was trying to focus more on healthcare at the time. And I'm still focused on healthcare and owning a lot of the stocks like Illumina, which I bought again in 2024, 2023 maybe even. And I still own it today, right? because it's largely been working for me finally. And also because I believe that healthcare has really been sort of one of the sectors that has been left behind.

8:58And I think it holds a lot of promise in the future, especially with AI. More recently though, I've noticed that the semiconductor rally was really about option markets. And it was more about option market chasing prices higher. And I noticed eventually that what was happening was that every I noticed that every time semiconductor stocks went up, software stocks went down and it became very apparent to me that that the trade has been own semis short software. So I was looking around at the software stocks and I realized like some of these things are incredibly cheap. Like when you look at them from a fundamental standpoint, because at the end of the day, fundamentals still matter, but they matter when they matter and they matter when And they're so cheap that are so expensive, you can't ignore it anymore.

9:53And so some of these names I thought were extremely cheap. And I thought the reason why they were so cheap was because of the trade that was taking place. And also, the more I've used AI and tools that software companies offer, the more I find that, yes, you can use AI on a platform. and yes, it makes it maybe that there may be less seats in the future, but I also noticed that they're now charging you more also to integrate AI into that platform. So now there's not only a subscription fee to owning QuickBooks, but if you want to use certain AI features on QuickBooks, for example, you might have to pay an extra fee to do that.

10:38And by the way, they've raised my price of my QuickBooks subscription like two or three times now in the last several months. And what am I going to do? Am I going to like uproot all, you know, the last 15 years of business that I've been acquiring on QuickBooks? No. So I went out and I looked it into it. I'm like, oh, wow, this stock is really cheap. And it's like trading at valuations that it hasn't seen in decades, almost like a really long time. It was trading at a price that hadn't been at since 2022. And I'm like, you know, if this AI thing, if I'm right about semiconductors and the short relationship that they have with software, then Intuit could be a really great opportunity.

11:18So I did that with Intuit and ServiceNow, and I bought both of them for my own portfolio. They haven't really paid off yet, but I'm thinking that if this whole semiconductor thing implodes, which I think there's a good chance that that probably happens at some point, that software will go back up. And when that happens, I think that some of these companies in the software space specifically are fairly undervalued at this point. And so I'm making a direct play on that. And I disclose all this stuff to my subscribers so they're all fully aware of what I'm doing. If the options market is going to be really dominant in the future, it's like, well, it makes sense to own where those options are trading, right?

12:02Right. So like recently, the CBOE fell quite a bit because the market was like worried about these perpetual future things that are coming out on some of these betting markets. Like I've missed this stock probably five times over the last three years. Every opportunity I've had to buy it, I never bought it because I always saw, oh, maybe it can go lower. So this time it came down and the valuation numbers looked somewhat attractive to me. So I'm like, ah, if I can't beat options, then I'm going to own them. And I'm going to own them by owning the exchange. And so that's another stock that I recently bought for myself.

12:39So I do incorporate a lot of the things that I see in the market into sort of my own investing philosophy. If I see like, I own like core positions in a lot of the MAG7 names. And so if I saw the reason why Apple's been rising because of something happening in the options market, which is really something that would fade perhaps after earnings, and if Apple's becoming too heavy in my portfolio, I might trim some Apple. Why not? If the options market is going to give me money for free and trade a stock up on noise, basically, then I'll take some of that profit off the table and maybe I'll find something I'm losing money in and offset the gain.

13:28But, yeah, so I think that the market today is it's so bifurcated. You have winners and you have losers and there's really nothing in between. But what's interesting is that the index is not reflective of the entire market anymore. At least the S &P 500 isn't in my view. It's reflective of like 10 stocks now. and I think there's a lot of stocks that have gotten left behind and I software is one part of the market for example that's been totally decimated and there's opportunities there that I think if you're selective with that probably work out just fine in the future and and so like I take advantage of those opportunities um you know when nobody wanted energy stocks at the end of last year you know but it looked to me it made no sense well how can gold and silver be going higher and everyone's worried about debasement and inflation.

14:27But oil is like the most important commodity in the world. And that's not going up. Like it makes no sense to me. Like if the dollar is going to zero, like people were who were only gold and silver were claiming, then oil should be worth a lot more in the future as well. It trades exactly the same way in terms of the dollar, you know, the dollar relationship as the other ones. So I'm like, well, if they're just going to give away oil. And, you know, so I went out and bought Occidental Petroleum. I mean, you know, if it's good enough for Warren Buffett, then it's good enough for me. And if especially when I'm trying to look for something in that space.

15:02So, I mean, look, I've made a lot of terrible choices, too. I bought Boston Scientific at a horrible price and I sold it at even worse price. I did the same thing with Zoetis. I mean, you're not going to get them all. But, you know, if you can get most of them right, you know, hopefully you make more money than you lose in the end.

15:19Michael Kramer:Would you say there are lessons that you learned with those Boston Scientific and Zoetas? What I do is I create like a watch list and I just watch stocks for sometimes a year or two, even understanding the story, understanding how the stock reacts, understanding what it's doing, understanding the drivers and looking for that moment where there's a really good opportunity where everything just comes together. So like Boston Scientific, I had watched it for two years go nothing but up. And it looked like it had been consolidating for a year. It looked like technically it was getting ready for a big move.

16:00Unfortunately, it moved big, but it moved big in the direction that I didn't expect. So I got that part right, but the direction wrong. But fundamentally, it made sense, right? I mean, the fundamentals seemed OK. The story was intact. And then they come out and they report earnings that caught everyone off guard. No one expected one part of their business to disappoint. It did. And I like to try to give things two quarters in a row to prove the market wrong. So Boston Scientific came out. I think I bought it in the 90s. And it came out, reported a really bad quarter. It went down a lot. I held on to it because I'm like, this could just be a one-quarter thing.

16:45I don't know. But the market moves so quickly, it doesn't really give someone the opportunity to try to give it time to work itself out. So the stock went down 20 % or 30%. I held on to it. Next quarter comes. It's bad again. The stock goes down again. I'm done. I'm out. That's it. Two quarters in a row. I lost 30%, 40 % now. I'm just moving on. But in fairness, what if the quarter had been good? right the stock could have been right back to where it was when i originally bought it so that's why i always try to give things like two quarters in a row and the same thing with zoetis it had reported you know two bad quarters in a row i lost was losing money in it it was coming to the end of the year i had capital gains so bye zoetis you know you didn't make me money i'm losing money now i need something to write some of the gains off and i just sold it and And but, you know, there's been times like where I bought things and they've gone down like into it, reported.

17:46I bought into it recently and it reported a quarter. The market didn't like the quarter. They didn't like the the the the turbo tax numbers. Stock goes down 20 percent. It goes down 30 percent. I looked at the option market. I was like, oh, they put walls at 260. I'm like, I'm going to hold it. If it breaks$260, then I'm going to have to think about maybe unloading it and just saying I was wrong. Option expiration comes and goes. $260 holds. Now the stock is right back almost to where I bought it. I'm still down like 10 % in it. But the idea being is that it, who knows? I don't know. I just try to use all the tools I have around me to try to make these assessments.

18:27And in that case, so far it's worked out. And I'm back to a much better spot than I was maybe in the middle of June.

18:35Michael Kramer:So aside from the narratives and aside from looking at how the market has evolved, is evolving, what are the other metrics or data points that you're using to assess these stocks and the market in general? I mean, I use some of the basic tools, you know, P ratios, sales growth, price to sales. I look at things like free cash flow, operating cash flow, very important to me. I look at a lot of those basics. I look at, you know, which way the macro wind's blowing as well, you know, and I try to understand, you know, what the Fed is likely to do and which way interest rates are likely to go and where's the economic strength overall.

19:19But those things have just mattered less. And while I try to factor into my into my analysis, just because I know that at the end of the day, it's probably going to come back to that at some point. I'm sure if we have a recession, that's all this macro stuff is going to really matter again. But for right now, it just hasn't. I think the transition in the Fed leadership also is changing things a little bit. But, you know, Jay Powell was someone that really wouldn't tolerate a higher unemployment rate. He liked having control over the market. He liked dictating the direction of it. Kevin Warsh seems to be a different animal where he's more willing to let the market do what it wants to do.

20:02And that's more of an older school approach that I think a lot of people probably haven't experienced. I mean, I remember there was a time, you know, before Ben Bernanke with Alan Greenspan. you had no idea what the Fed was going to do going into an interest rate decision. The only thing you knew was based off of what Fed fund futures were telling you. And they used to joke on TV, they used to call it the briefcase indicator. If the briefcase Alan Greenspan was carrying was really thick, it meant there was a good chance they were going to hike. If the briefcase was really thin, then it was going in and probably nothing was going to happen.

20:37I mean, it was a joke, but every once in a while it might actually work out that way. But with J-PAL, you knew every single time what he was going to do before the meeting ever took place because the market had already figured it out. There were people talking literally multiple times a day, it felt like, from the Fed leadership. And all that stuff has died down a little bit. So now you are starting to see the market move a little bit more on its own. And I think it's going to take a little bit of an adjustment period for that to really kind of play out. I think you're seeing it mostly in bonds right now.

21:11At some point, maybe equities do too. But right now, like I think for the most part that the macro stuff, as much as it matters, I think the fundamentals and the macro take sort of a backseat to the other things that I talked about at the very beginning.

21:31Michael Kramer:Anything further you want to say about bonds? I mean, I've been bearish on bonds for four years now. I thought that rates should have been higher a long time ago. I still think they should be significantly higher. And I'm not talking about the Fed funds rate. I'm talking about the 10-year and the 30-year. I think the 30 year could be 6%. I think the 10 year could easily be over five. Just because if you look at the steepness of the yield curve, it's fairly on a historical basis. Again, this is where you get, you know, can be really tricky because on a historical basis, you look at the steepness of the yield curve.

22:09It's kind of flat, you know, compare comparatively speaking when the 10 year typically tops out around 300 basis points above the two. I mean, I don't even know what the yield is today. I think it's 40 basis points or something. So the yield curve is very flat, in my opinion, from that standpoint. So, I mean, all of a sudden you're talking about a 10 year that's up well beyond 6 percent, if that were the case. And I still think that's possible. I don't think that I think the economy is strong. I think the J-PAL Fed didn't really do enough to bring inflation back to target. And I think that they were sort of afraid to really go all the way because of the pain it might cause on the economic and employment side of things.

22:58And then I think by the last six months of his term, he was pretty much done doing stuff because he didn't want anything to break. And I think now Kevin Warsh is kind of left in a difficult position. And if you kind of look at his history, I mean, I would certainly think he sounds and seems more hawkish than the J-PAL Fed.

23:20Michael Kramer:And what would you say about the coming months, the coming weeks, coming months in the market? What would you say? I saw a nice MarketWatch article that quoted kind of being cautious going into September. But what else would you encourage investors to be thinking about? I would say that the overall index itself is misleading, I think. I think it's only really like I said earlier I think it's representative of only a handful of names right now I mean like Walmart reported results today right and I feel like you know with stock is down something like nine percent I feel like that would have been a much bigger story you know before 2020 Walmart probably also would have had a bigger stake in the S &P 500 at that point literally someone said to me the other day well you still have the retailers to report and I'm like who Who cares?

24:13They're not going to move anything. They're not even important anymore. Like, you know, Walmart's going to. OK, who cares? You know, it's like it doesn't matter. And you could see the S &P was down like 60 basis points or something. It doesn't even matter. Right. But I think there's a lot of stocks out there that are, in my opinion, have been left behind and are relatively, you know, nicely priced, which means that there's opportunities. And if the index goes down 10%, it doesn't mean that every stock in the index is going to go down. There could be positions out there where everyone's been short this stuff.

24:49And so when the market actually goes down, they're going to be forced to cover their shorts, which means they'll go up. And so I think you have to be sort of mindful of the idea that the market is not the market. The index, I think, could go down as a whole. But I think that the underlying names within the index, there's lots of them that could actually benefit from that. And a few of them I've already told you.

25:13Michael Kramer:I was going to say, maybe if I can pick apart a little bit at the stock like Illumina, you were saying why you liked it. If you go on the quote page on Seeking Alpha, you can see that it has had for in recent history consistently low grades on valuation and growth. Maybe talk about the metrics that you're paying more attention to in that stock and how they're helping you stay bullish? So I think like in that stock, it's really very simple. I'll tell you exactly how I got into Illumina. So Illumina owned a company called Grail. And Grail is a multi that it's a it's a cancer detection company. They take a blood sample.