A “Tax Avoidance Sell-Off” in January 2024? Using Apple Puts to Hedge my US Exposure
The end of the year is always a good time to reflect on what has happened throughout the year and how to optimally position for what may lay ahead. My article one year agon on “Tax Loss Selling, Window Dressing & The January Effect in 2023” was spot on and laid the foundation for an outstanding year, in which my portfolio was up more than 150% (but more on that in a separate post early January).
December 2023, frankly, does not seem as much a fertile ground to hunt for potential victims of tax loss selling as last year did. The reason is obvious, there were not many losers in 2023 with the S&P 500 up 24% ytd, the Nasdaq up 44% ytd, and the ARK Innovation ETF (unprofitable growth proxy) up 72% ytd.
After such a strong year, “tax avoidance” though might be an interesting theme when it comes to anticipating near term returns. The following tweet sums it up perfectly:
“There is 30% of my book I’d love to exit, but waiting until 2024 for tax reasons. My gut is telling me January will be the mirror image of Q4 2023 (sadly).”
I believe some stocks have run way too hot in 2023 relative to their fundamental performance. First and foremost to my mind comes Apple, which is up 49% ytd despite falling revenues. Apple is now trading at a P/E ratio of 32, which is extremely rich for a no growth stock. I would not be surprised to see Apple giving back much of its 2023 gains in Q1 2024. Tax avoidance is one potential reason why Apple stock has run so far in Q4 2023, despite problematic fundamental news. For example, Apple is now banned from selling its latest Apple Watches in the US. To hedge my US exposure going into 2024, I have bought a 0.5% position in Apple puts with an expiration date of February 2024 and an exercise price of $190. The expiration date will be sufficient to capture any January 2024 “tax avoidance” effect, should apple investors finally decide to cash in on their enormous (and IMO lucky) 2023 gains. Moreover, it will capture any sell-off following earnings which should be released by the end of January. If Apple falls 10% from the current price of $193, the put options would be worth $16.30, which would represent a return of 260% on today’s cost of the options of $4.4. One reason for this, in my opinion, highly attractive pay off profile for the options is also the extremely low level of implied volatility in the current market. The VIX is currently trading near all time lows.
Quo Vadis US? Why I am getting more cautious on US stocks
My untypical move to by put options is also motivated by my growing sceptic about the US economy, at least in related to the rock solid health that the US equity markets seem to imply.
One year ago, everyone and their dog was anticipating a US recession, which did not materialize so far. The recession worries were driven by a high level of reported inflation and the anticipation of an extremely excessive monetary policy to fight it off. The Fed certainly did deliver on the expectations with regards to its tightening campaign. However, the recession did not occur and now the market consensus is that the recession is cancelled overall. Whether we call it soft landing, or no landing, or goldilocks scenario, the market seems convinced that the fight against inflation is won (I agree) and that the Fed can ease its monetary policy without causing a recession (I have my doubts).
My concern with the current market consensus is the following:
1) the level of rates is now more than 1% higher than one year ago, and more importantly:
2) it’s the duration of restrictive policy that matters. The longer tight policy is in place, the higher the likelihood of recession.
The Fed cutting once or twice until mid 2024 will do pretty much nothing in terms of easing the current overly restrictive monetary policy, but we will have 6 months more of it by then.
The reason why I am call calling the current monetary policy overly restrictive is that I am convinced that inflation is actually way lower than implied by the official CPI if it wasn’t for the ridiculously flawed shelter measure. According to the Penn State Alternative Inflation Index, which uses a realistic real time measure for shelter, the current inflation rate is rather 0.5% (blue line) than the official inflation rate of 3.1% (red line).
If correct, the current level of real interest rates is actually around 5%(!)
In my view, the longer the extremely tight monetary policy goes on, the higher the probability that things break. Based on google trends data, the global consumer and the US consumer already seem to be under pressure. A few days ago I checked year over year data for the willingness of the consumer to spend and I am observing a significant deterioration:
Google trends year over year (US in brackets):
„Hotel“: -21% (-16%)
„Flight“: -14% (-37%)
„Restaurant“: -21% (-20%)
„iPhone“: -14% (-24%)
US GDP growth has likely only held up well so far in 2023, due to unprecedented levels of government spending. The current deficit at which the US is operating is in my view unsustainable, so the fiscal impulse is also about to fall off a cliff in the near term.
In sum, I would not go so far as calling for a US recession in 2024, but I am clearly comfortable to take once again a contrarian take relative to the market consensus. I believe the odds for a recession are significantly higher than priced by the market. At the same time, US stocks seem priced close to perfection.
Going into 2024, I am therefore strongly underweighting US stocks relative to the MSCI World benchmark. While other economies may be in an even more concerning state of high interest and a vulnerable economy, hardly any other markets seems as expensive as the US at this point, so I am getting extremely selective with my positions.
The Case For Emerging Markets in 2024 (and Beyond)
Where else to invest if not in the US? Searching for alternatives to the expensive US market, I have been looking at Europe as well as Emerging markets, in particular South East Asia and China.
Unfortunately, Europe is facing the same mix of, in my opinion, an overly restrictive monetary policy combined with a fragile economy. At least, valuations seem way more modest than in the US at this point. I have some European positions and intend to hold on to them going into 2023.
What stands really out to me at this point is the attractiveness of emerging markets. Blending out China, major emerging market countries such as India or Indonesia demonstrate strong and stable GDP growth of 5% and more, as well as almost perfect demographic distributions of their population. I believe there is a strong case to be made that South East Asia will be the growth motor of the global economy for decades to come. As GDP per capita and the population in these countries keep rising, their economies should prosper and their stock markets produce many winners.
However, emerging markets have significantly underperformed global stock markets in recent years, allowing for a potential reversion:
Polen Capital has done a great job pitching the contrarian investment case for emerging markets this summer: Emerging Markets: A Rare Window of Opportunity I allow myself to borrow two key figures from their report that do a great job illustrating how cheap emerging markets are at this point, both absolutely, and relative to the US stock market.
The figure below shows that Emerging Markets currently trade at an unprecedented discount relative to US stocks.
The following figure hints at the extent to which emerging market stocks are currently neglected. Global active managers are currently underweighting emerging market stocks by 42% relative to the benchmark MSCI world index.
Frankly, at this point even an index investment into emerging markets seems to have good chances to do well, but I believe there is a chance to do much better by selectively picking the most promising and most undervalued companies in Asia.
Polen Capital puts the case well that quality companies seem to be on sale exactly as much as lower quality companies:
Companies in the top ROIC quintile have historically traded at an average of 1.2x times the broader market. This reflects that investors are generally willing to pay more for companies with robust fundamentals. However, the relative P/E of high-ROIC companies at the end of June was only 1.0x the rest of the Index. This indicates that the highest-quality companies in EM are priced similarly to low-quality businesses.
I will reveal my exact positioning for 2024 soon and will keep you updated about which companies in South East Asia and China may show among the most promise in my opinion.