No Sleeping at the Wheel II

For only the second time since 2011, the equity markets have sold off more than 10%. Typically in a rising stock market driven by a growing economic cycle, we experience a 10-15% pull-back once every year. We view this type of market action as a healthy exhale. From historical highs set on January 22, the Dow Jones Industrial Average has dropped -6.72%, and the VIX, (CBOE Volatility Index) has spiked a dizzying 184%. We avoid making short-term predictions, but view this dip as what will play out as a very short-term technical sell-off. For the stock market to enter a sustained bear market, the underlying economy must first enter recession. Two things happen in advance of a recession – the Leading Economic Indicators drop for several consecutive months, and the yield curve inverts, which is a fancy way of saying short-term interest rates rise above long-term interest rates. Neither of these fundamental conditions currently exists, and we believe it will take at least 12-18 months for either of those two conditions to develop. Once the LEI’s drop and the yield curve inverts, it typically takes several months for the underlying economy to slow. We have gone on the record that the current secular bull market will last a minimum of 2 1/2 more years, and nothing in the markets or economy has fundamentally changed over the past two weeks to change that outlook.

The last time this happened was on August 21, 2015. The U.S. equity markets lost over 3% in one day, snapping investors awake from the lazy days of late summer. For the first time since 2011, the markets had dropped more than 10% from their recent all-time record highs. We published an article back then that we viewed the drop as a healthy exhale and a potential opportunity for investors to move cash into the market. Usually it takes 15% to get our attention, but a few key occurrences grabbed our attention that summer. That day, the VIX (volatility index) rose a dizzying 46%, and the breadth of declining stocks represented well over 90%. The yield curve was normal (upward sloping) and the Leading Economic Indicators were rising, so we viewed the sharp sell-off as short lived. A year later patient investors were rewarded with a 6% rise in the market.

© 2018 Pawleys Investment Advisors, LLC. All rights reserved.

Pawleys Binary Event Trade Outcome

In May of 2016, a client asked us to review the choices within her 401(k), which included company stock.  There was, at the time, a pending buy-out of the company, so when we reviewed the stock, we anticipated that it would be trading at parity with the buy-out price.  The board of directors and shareholders of both companies had already approved the transaction.

Much to our surprise, the company stock of our client was trading at a 35% discount to the buy-out level.  Clearly, the market did not believe the transaction would complete.  The merger was being reviewed by the Department of Justice for anti-trust issues.  Several high-profile mergers had fallen apart amidst government anti-trust concerns, including Office Depot & Staples, Sysco & U.S. Foods, and Halliburton & Baker Hughes.  We classify a pending buy-out which may be blocked as a binary event.  There are only 2 possible outcomes: either the companies will merge, or they will not.  We liked the fundamental financials and the valuation of the stock, and recommend a long position to the client regardless of the outcome of the pending merger.

How does the story end?  The merger fell apart.  Both the Department of Justice and a U.S District Court judge ruled that the merger would have violated Section 7 of the Clayton Antitrust Act.  This spring, the acquiring company announced it was backing away from the acquisition.  But the trade worked out due to the solid fundamentals of the company.  We entered the stock at $130/share, and it recently traded at $193, representing a 48% premium over 17 months.

© 2017 Pawleys Investment Advisors, LLC. All rights reserved.

Performance for Investors – Pawleys Growth Fund

Amazon’s proposed buy-out of Whole Foods has been publicized as a game-changer to the consumer space.  For me, it is continued validation that the stock selection criteria for the Pawleys Growth Fund is solid, as it represents the 9th buy-out from the holdings since 2011.  Typically, the fund holds 20-25 positions, reflecting my best high-conviction ideas, so the number of premium buy-outs is stunning, while humbling.  Below is a summary of the premiums generated for investors in the Pawleys Growth Fund:

Pawleys Buy-Outs June 2017

© 2017 Pawleys Capital Management, LLC. All rights reserved.