Quality in the Streets, Momentum in the Sheets | TCAF 217

Key Concepts

• Rare Earth Metals: Essential for modern technology and defense, with China dominating production and refining.
• Supply Chain Security: A growing global concern, driving efforts to diversify rare earth sources.
• VANC REMX ETF: An investment vehicle providing access to the rare earth and strategic metals ecosystem.
• Market Sentiment Shift: A move away from AI capex beneficiaries towards quality and defensive sectors.
• Momentum Factor: Dominant in recent markets, but showing signs of reversal.
• Quality Factor: Increasingly outperforming as market sentiment shifts.
• AI Capex Story: Under scrutiny regarding profitability and financing schemes.
• Palantir Earnings Reaction: A "good news, bad price action" event signaling a potential market turn.
• Nvidia Earnings: Anticipated to be positive but potentially priced in, with Nvidia seen as a "caboose" of the AI train.
• Masayoshi Son's Nvidia Sale: Interpreted as a liquidity play for other AI investments, not a market signal.
• Market Structure Changes: Faster corrections and snapbacks due to quantitative strategies and algorithms.
• High Capex Stocks: Historically underperformers, but have driven recent market gains.
• Oracle and OpenAI Deal: A cautionary tale about debt-funded innovation and market skepticism.
• OpenAI's Financials: Significant losses projected, funded by hyperscalers, with questions about future profitability and IPO.
• Healthcare AI: A potential growth area for AI adoption, with implications for drug discovery and research.
• Global Central Bank Policy: Over 80% of central banks have cut rates, a positive signal for markets.
• Inflation: Primarily a US problem, with lower readings in Europe and Asia.
• Fiscal Policy and Deregulation: Perceived as positive sentiment drivers, though difficult to quantify.
• Dow Outperformance: Driven by financial stocks like Goldman Sachs and Robinhood.
• Bond Market Volatility: Significantly lower than in previous years, supporting credit availability.
• Secular Bull Market: Supported by global easing, strong earnings, and investor optimism.
• Skepticism and Doubt: A persistent market sentiment, with reasons shifting over time.
• Human Nature and Risk Aversion: Older investors tend to be more bearish due to higher stakes and psychological impact of drawdowns.
• Family Office Crowd: Often vocal about market downturns, with motivations questioned.
• Younger Generation's Bullishness: Potentially influenced by market performance during their lifetime.
• Market Cap Weighted vs. Equal Weighted Indices: A recent shift favoring equal weight suggests broader market strength.
• Diversification of Factors: The importance of combining quality, momentum, and growth for a robust strategy.
• Jot T ETF (VTUSQM): A rules-based ETF employing quality, momentum, and equal weighting.
• Rules-Based Strategies: Emphasized as crucial for navigating future market volatility.
• Active vs. Rules-Based ETFs: Distinction between personality-driven active management and systematic rule execution.
• "The Rinse": The process of removing underperforming or high-beta assets during market downturns.
• Market Personality: The idea that markets exhibit distinct characteristics that can be identified and traded.
• Midterm Election Year Statistics: Historically positive market performance in the 12 months following midterm elections.
• Predictive Analytics and AI: Potential to democratize sophisticated trading strategies.
• Quality Definition: A blend of balance sheet strength (ROE, Debt-to-Equity) and sustainable revenue growth.
• Factor Diversification: The benefit of combining multiple factors (quality, momentum, growth, equal weighting) to act as a "shock absorber."
• Drawdown Mitigation: The ability of a strategy to limit losses during market downturns.

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Rare Earth Metals and Supply Chain Security

The episode begins by highlighting the critical role of rare earth metals as the "hidden backbone of modern technology and defense," powering everything from smartphones and electric vehicles to fighter jets and wind turbines. The sponsor, VANC, is recognized for its early foresight in launching the rare earth and strategic metals ETF (REMX) 15 years ago, well before supply chain security became a global priority. The current dominance of China in production and refining capacity presents significant challenges to global supply security, essential for technological innovation, clean energy, and national security. This has prompted a global race to build independent supply chains and reduce reliance on China, leading to rapid investment growth across the rare earth ecosystem, from mining to advanced manufacturing, accessible through REMX.

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Market Sentiment Shift and the AI Capex Scrutiny

The discussion pivots to recent market dynamics, with Joe Teranova noting a significant shift in the last 10-14 days. He describes it not as an "unraveling" but as a period of "doubt" surrounding the biggest winners of the past three years' bull market. The AI capex story is now "fully under the microscope," with media outlets questioning the profitability of these companies and the potential for "circular financing schemes," drawing parallels to the late 1990s. The market is described as "getting weird," with established winners being called into question.

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The Momentum Reversal and Hedge Fund Positioning

To understand market turns, the speakers emphasize looking at the hedge fund community. It's revealed that momentum has been the dominant factor since the Federal Reserve's first rate cut in September 2024, outperforming quality by 1,000 basis points. This momentum is likened to a "battleship" that turns slowly. While individual equities have seen momentum, macro assets have also been influenced. The trade for speculators and hedge funds going into Labor Day was shorting the dollar, long crypto, and long precious metals, which was performing well. Leveraging this, the rare earth and minerals trade was also favored.

However, a reversal occurred around September 17th, with the dollar reversing and moving higher. Crypto peaked on October 6th and has since declined. Precious metals (gold, silver) peaked in mid-October, followed by rare earths and minerals. This reversal is expected to eventually impact the equity market as leverage is withdrawn and speculators reduce positioning.

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Palantir as a Market Indicator: "Good News, Bad Price Action"

The case of Palantir is presented as a prime example of this market shift. Despite delivering "blowout numbers" and a strong conference call where the CEO defiantly challenged short-sellers, the stock did not rally as expected. This phenomenon, termed "good news, bad price action," is a classic indicator that speculators are looking to reduce risk rather than add to it. It serves as a "heat check" and "sentiment check" for the market. The speaker suggests the CEO's aggressive stance was a mistake, and a simple "mic drop" would have been more effective.

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Nvidia's Upcoming Earnings and its Role in the AI Ecosystem

Nvidia's upcoming earnings report is discussed as another potential market-moving event. While it could reverse the market higher, there's a sense of desensitization to Nvidia's reports, as its customers' outlooks are already known. The general consensus is that Nvidia's performance is largely priced in. However, if Nvidia significantly exceeds expectations and reaches new all-time highs, it would be positive for the market.

Crucially, Nvidia is positioned as the "caboose of the train" in the AI ecosystem. Its innovation enables AI spending, but the companies actually doing the spending will be the first to know if they want to continue. Nvidia's forward-looking guidance is reactive to incoming orders, not leading.

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Masayoshi Son's Nvidia Sale and Market Structure

The sale of Masayoshi Son's position in Nvidia is dismissed as a significant market signal. It's interpreted as a liquidity play to fund investments in other AI companies, not a rotation into different sectors like healthcare or defense.

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Is This a Market Top? The Impact of Market Structure Changes

The question of whether this is a market top is addressed. The speakers argue that market structure has changed dramatically over the last five years. Despite significant S&P 500 gains, there have been sharp corrections. The current dominant factor is quantitative strategy, where algorithms react similarly and simultaneously, leading to more violent corrections and even more violent snapbacks. This rapid nature means retail investors may not have time to react. Unlike the prolonged sell-off in 2022, which was tied to aggressive Fed rate hikes, current corrections are expected to be shorter due to these structural changes.

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The Anomaly of High Capex Stocks and Debt-Funded Innovation

A chart from Kaiwan Capital highlights that high capex stocks are typically "shitty investments," underperforming by an average of 6.7% annually from 1996 to the present. However, this year, companies heavily invested in AI capex have seen significant gains (average of 45%), while those not spending have lagged (2.2%). This anomaly raises questions about whether companies are "high on their own supply" or overdoing it.

The Oracle and OpenAI deal is cited as a reminder of the sensitivity to debt in funding innovation. While many believed companies were using cash flow and not debt (unlike in 1999), Oracle's high debt-to-equity ratio (above 500%) brought this concern back. The market's reaction to Oracle's announcement of a potential $300 billion contract with OpenAI, which gave back all gains and then some, indicates skepticism. The market is questioning OpenAI's ability to follow through with such spending, given its ties to other companies like Microsoft.

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OpenAI's Financials and the Future of Private Companies

The discussion delves into OpenAI's financial situation. Microsoft consolidates a portion of OpenAI's losses, leading some analysts to estimate annual losses of up to $70 billion. While revenue is growing rapidly, the funding comes from hyperscalers like Microsoft and Amazon, using their cash flows. The question of OpenAI going public is raised, with backers likely seeking liquidity. The existence of a significant secondary market for its shares suggests a need for a public offering sooner rather than later, as trust in these complex relationships and spending may eventually wane. The situation is compared to Facebook's pre-IPO period, where valuation doubts were prevalent.

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The Bullish Premise: AI in Healthcare and Global Easing

Despite the skepticism, the bullish premise for AI remains strong, particularly in its potential to improve the environment and the healthcare industry. AI adoption in healthcare is seen as lagging but poised to be a powerful tailwind. The high cost of research in healthcare, involving highly paid individuals and long timelines for drug discovery, could be significantly reduced by AI, impacting earnings expectations.

The broader market is supported by several factors:

• Global Central Bank Easing: Over 80% of central banks have cut rates, historically a positive indicator.
• Controlled Inflation: Inflation is primarily a US issue, with lower readings elsewhere.
• Double-Digit Earnings Growth: The market has experienced four consecutive quarters of double-digit earnings growth, with expectations for continued growth.
• Fiscal Policy and Deregulation: Perceived as positive sentiment drivers, though difficult to quantify.
• Lower Energy Prices: A contributing factor to economic stability.
• Calm Bond Market Volatility: Tight ranges in Treasury yields facilitate planning and credit availability.

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The Psychology of Skepticism and Investor Behavior

The persistent doubt in the market is attributed to human nature. When things are good for a long time, the mind tends to invent ways for them to end badly. Older, more successful individuals often become more bearish because they have more to lose and have witnessed the psychological and financial damage of drawdowns. The constant stream of bearish commentary from billionaires and family offices is questioned, with the motivation to scare others being unclear.

Conversely, the younger generation shows a higher level of engagement and bullishness, possibly due to market performance during their lifetimes. The speakers emphasize that long-term optimism consistently prevails over short-term pessimism.

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Market Cap Weighted vs. Equal Weighted Indices and Diversification

A recent dynamic observed is the outperformance of the equal-cap weighted index over the market-cap weighted index, a reversal of a decade-long trend. This suggests broader market strength beyond the mega-cap tech stocks. The dominance of a few mega-cap stocks in market-cap weighted indices like the S&P 500 raises questions about their validity as benchmarks and the pressure on financial advisors to concentrate portfolios.

The importance of diversification is reiterated, not just across asset classes but also across factors. The Jot T ETF (VTUSQM) is presented as an example of a rules-based strategy that combines quality, momentum, and equal weighting to capture market personality and act as a shock absorber during downturns.

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The Jot T ETF: A Rules-Based Approach to Market Capture

Joe Teranova explains the philosophy behind the Jot T ETF. It is a rules-based, non-discretionary strategy that aims to provide a core equity holding for portfolios. The strategy rebalances and reconstitutes quarterly, driven by predefined rules rather than active stock picking or conference call analysis. The goal is to capture the "personality of the market" and act as a shock absorber during periods of turmoil.

The definition of quality within the strategy is a blend of traditional metrics like Return on Equity (ROE) and Debt-to-Equity ratio, combined with revenue growth over a three-year period to ensure sustainability. This multi-factor approach (quality, momentum, growth, equal weighting) is likened to building a championship team, where different players contribute at different times.

The strategy's ability to mitigate drawdowns, as demonstrated in the 2022 bear market, is highlighted as a key benefit. The ETF's wrapper is crucial for executing these rules, especially when it involves selling a stock at a loss and then buying it back at a higher price, a decision that would be psychologically difficult for individual investors.

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Midterm Election Year Statistics and Market Rationale

The historical data on midterm election years is presented as a remarkably consistent predictor of positive market performance. Since World War II, the market has delivered positive returns in the 12 months following every midterm election, with 14 occurrences of double-digit gains. The rationale behind this phenomenon is not explicitly explained, but it's presented as a factual observation that can inform investment decisions, particularly during market downturns. The speakers emphasize identifying factors with an edge, regardless of the underlying "why," similar to how sophisticated trading firms operate.

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The Future of AI and Predictive Analytics

The conversation touches upon the increasing role of artificial intelligence in financial markets. While current AI models like ChatGPT cannot provide financial advice, the potential for AI to analyze vast datasets and identify profitable trading circumstances is immense. This could democratize sophisticated trading strategies, making them accessible to retail investors, similar to how Jane Street and Citadel profit from identifying market edges.

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Looking Ahead: Personal and Professional Aspirations

The episode concludes with the speakers sharing what they are looking forward to. Michael Batnik is anticipating more prediction markets and a trip to Disney with his children. Joe Teranova is looking forward to his children's future endeavors, both personally and professionally, and continuing his own work. He also expresses anticipation for future golf outings with Michael. The overall sentiment is one of optimism and a commitment to navigating the evolving market landscape.