6 November 2022

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6 November 2022

Dear Investors and Traders,

The month of October turned out to be one of the most bullish months this year, gaining +7%
for the S&P 500 (SPX). While the start of November has started on a bearish note (after Fed
Chair Powell’s hawkish speech on 2 November, there is still a good chance that markets can
rally towards the end of the year.

S&P 500 (SPX) Daily Candles (Year to Date)

In the month of October, markets breeched the 17 June low and made a new low on 13
October. However, the SPX has since rallied strongly after making a classic double bottom
pattern. This rally has been driven by a few factors…

a) The market was technically oversold (sentiment at extreme fear) and on the weekly
candle chart, the psychologically strong 200MA acted as a support. So, a price
rebound was not unexpected.

S&P 500 (SPX) Weekly Candles

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b) Quarter 3 S&P 500 earnings came in better than expected. 70% of companies
exceeded earnings expectations and blended earnings grew +2.2%

c) After declining for the first 2 quarters, Q 3 GDP came in at +2.6%, showing the
resilience of the US economy (Q4 GDP initial estimate at +3.1%)
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What was also interesting was that the SPX continued to rally despite the market generals
(MSFT, META, GOOGL, AMZN, TSLA) suffering big declines after their earnings
announcements.

Prior to this bear market, AMZN, TSLA, MSFT, META, GOOGL and AAPL made up 25%
of the market value of the S&P 500. Their price movements significantly impacted the
direction of the S&P 500. The fact that the SPX could continue to move up despite these 6
market generals moving down, is a bullish sign. It shows the broad strength of the overall
market.

A war ends when the generals get shot. Similarly, in past bear markets, the strongest stocks
were usually the last to decline. When the strongest stocks eventually fell, it usually signaled
the tail end of the bear market. The fact that the strongest stocks like MSFT, GOOGL,
AAPL, TSLA are cracking is a possible sign that the end of the bear market could be closer
than we think. AAPL is holding up the best so far. I am still hoping for this last general to get
shot in order to buy back in.

Fed Powell Does Not Like the Stock Market Going Up Too Fast

The market rally ran into a brick wall during the Fed FOMC meeting on 1-2 November.
Initially, the SPX was holding up well when the Fed raised the fed funds rate by 0.75% to the
range of 3.7%-4% as expected. The official Fed statement actually indicated the Fed’s
intention to slow the pace of interest rate increase as soon as the next meeting (December) or
the one after that (February).

However, during the press conference, when a reporter told Powell that the market was
reacting positively, he looked frustrated and began to make a series of statements that were
very hawkish and in direct contradiction to the official Fed statement. He said, “Inflation has
not changed from the time we started 12 months ago. We are not thinking of pausing. The
terminal rate will be higher than what is expected”. It was that moment that the market started
crashing down.
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It is clear that the Powell’s top priority is to bring inflation back down to its long-term rate of
2%. To achieve this, Powell believes that he needs to reduce demand by first making people
feel poorer. His plan is to increase the unemployment rate, to reduce wage growth and to
bring stock and asset prices down. This is all a necessary evil to kill the inflation monster. In
other words, Powell does not want the stock market to go up too fast.

Obviously, if you want the stock market to go up rapidly in the short-term, this seems like
bad news. However, if you are investing to accumulate wealth for the longer term in order to
achieve financial freedom, I think this can be a GOOD THING.

I believe that short term “pain” will lead to “long-term gains”. By aggressively tightening
now and ensuring that the inflation monster is killed, this will ensure long-term stability and
growth in the economy, which will ultimately be good for our businesses and stocks over the
long-term.

At the same time, the current sell-off in stocks is also a blessing in disguise for investors with
a long-term goal of wealth accumulation. In the short-term, it allows you to take your time to
slowly accumulate larger stakes in the highest quality companies at bigger and bigger
discounts.

When I read how some people are angry at the Fed for ‘crashing the markets’, I cannot help
but think how short-sighted they are. It is like being angry with your doctor for prescribing a
strong medicine to help you become healthier and stronger eventually. Yes, the medicine may
taste bitter and make you nauseous for a while, but it’s necessary to kill the virus for the good
of your long-term health.

Markets May Still Continue to Rally

The interesting thing is that two days after Powell’s hawkish comments, two Fed Officials
(Barkin & Collins) came out to walk back some of his aggressive rhetoric by saying that
there is a possibility for slower rate hikes ahead.

Together with news that the unemployment rate came in higher than expected at 3.7%, the
market managed to stage a rebound on Friday (4 November). This may indicate that while the
Fed does want the stock market to rebound too fast, they do not want it collapsing either.

I think the October 12 bottom can hold and this rally can continue if inflation indicators to be
released over the rest of the year show more signs of moderation. At the same time, if
Republicans can re-take the house and senate, that would also be a strong bullish catalyst.
Generally, when the President’s party loses control of the house and senate, it causes
government gridlock, which is a very bullish development for businesses and stock markets.
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Mr Market Hates My MAAMA

Among my portfolio of stocks, my core holdings are what I call my MAAMA stocks.
Microsoft (MSFT), Amazon (AMZN), Adobe (ADBE), Meta (META) and Alphabet
(GOOGL). These 4 business dominate their respective industry with wide economic moats
(brand monopoly, high switching costs, network effects and huge economies of scale).

Over the last 10 years, they have been among the market leading stocks, outperforming the
S&P 500 by a wide margin. I have no doubt they will continue to outperform the market and
generate double-digit returns over the next 10-20 years. They are amongst the highest quality
businesses in the world with high return on equity, return on capital, large profit margins and
fortress balance sheets.

However, Mr Market seems to hate my MAAMA in this present bear market. Since the bear
market began they have declined 38% to 77% from their peaks, far greater than the 27%
drawdown in the S&P 500 and the 37% decline in the Nasdaq 100.

Price Decline YOY Revenue Change (Constant Currency)

MSFT -38% +16%
GOOGL -45% +11%
AMZN -53% +19%
ADBE -60% +16%
META -77% +3%

Some investors may have a hard time understanding how such highly profitable stocks can
decline like money losing crap stocks. There is nothing wrong with the fundamentals of the
underlying businesses. If anything, the businesses are generating much higher sales and have
captured more market share than a year ago. The economic moats of these businesses remain
as strong as ever.

The main reason why their share prices have declined is because they happen to be in sectors
that are currently hated (out of favour). The rapid rise in interest rates have triggered a
rotation of liquidity out of sectors like Technology (i.e. MSFT, ADBE), Consumer
Cyclicals/Discretionary (AMZN) and Communications (META, GOOGL) and into sectors
like Energy, Utilities and Consumer Defensives

From the table below, you can see that year to date, the Consumer Cyclical, Technology and
Communication services have had the biggest drawdowns in market prices. At the same time,
sectors like Energy, Utilities and Consumer Defensives have gained or held up better with
money liquidity rotating into them.
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If I can use an analogy, these businesses are like cruise ships that happen to be in a part of the
sea that is experience a low tide of liquidity. No matter how fundamentally great these cruise
ships are, they will go down temporarily with the falling tide.

In my portfolio, my health care stocks (United Health (UNH), Johnson & Johnson (JNJ)),
Defensive restaurant stocks (McDonalds (MCD), Yum Brands (YUM)) and financial stocks
(Mastercard (MA), Visa (V), CME Group (CME)) have outperformed the S&P 500 because
they happen to be in sectors that are experiencing less liquidity outflow.

Always remember that in the short-term, market price movements can have nothing to do
with the fundamental value of the underlying business. In a bear market, falling prices causes
a flood of selling (panic selling, forced selling of margin accounts, short selling by algos) that
overwhelms buyers. This is when bargains are created. Stocks get crushed, not because of the
company fundamentals, but because of liquidity problems (buying volume not enough to
absorb the selling volume).

“Often, there is no correlation between the success of a

company’s operations and the success of its stock over a
few months or even a few years.

In the long term, there is a 100 % correlation between the

success of the company and the success of its stock. This
disparity is the key to making money; it pays to be patient,
and to own successful companies”,

Peter Lynch, Legendary Investor

Just like the tides in the ocean, the rotation of money into sectors is a temporary cycle. When
the sentiment of the market shifts, liquidity will start moving back into the technology,
consumer cyclicals and communications sector. Areas of low tide will become high tide and
areas of high tide will become low tide, and the cycle repeats.

When this bear market ends and the next bull market cycle begins, you will see the opposite
happen. The technology, consumer cyclical, communications sectors will be the strongest
gainers and the energy, utilities and consumer defensives will likely underperform the
market.

In the short-term my defensive restaurant stocks (MCD, DPZ, YUM) may be outperforming
my Technology stocks (MSFT, ADBE, NOW). But I am pretty sure that over the longer term,
my technology stocks will way outperform my restaurant stocks. The reason is because the
underlying technology businesses tend to have much higher return on capital (ROIC), higher
profit margins, wider moats (higher switching costs) and are much more scalable.

In the short-term, what goes up and down is driven by emotions, news and sentiment. It’s
very tough to predict which sectors or stocks will be loved or hated by Mr Market. However,
over the longer-term it is very easy to predict which stocks will outperform the market. This
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is because it is the fundamentals of the underlying business that will determine the long term
performance of the stock.

If you buy and hold companies with the widest moats, the highest return on capital (ROE,
ROIC), the strongest balance sheets and the higher profit margins, you will very easily
outperform the market indexes.

Why ADBE, META and AMZN are Being Specially Hated

My portfolio stocks ADBE, META and AMZN have seen some of the biggest percentage
declines this year.

Why has this happened? Besides belonging to the most hated (out of favour) sectors, these 3
stocks have been exceptionally punished because they have been spending billions of dollars
on R&D, acquisitions and growth capital expenditures. This has caused them to report short-
term declines in net income and free cash flow.

When ADBE announced that they were making a $20 billion acquisition for Figma, their
stock price crashed another 25%. When META announced that they were going to further
increase their operating expenses and Capex for the next 2 years, their stock price crashed
another 29%. When AMZN similarly announced another quarter of lower profits and
negative free cash flow, their stock cratered another 20%.

As an investor in these 3 companies, I am actually supportive of what they are doing. Instead
of choosing to focus on short-term profitability, they are investing heavily into R&D and
capex in order to further strengthen their competitive advantage (widen their moat). This will
lead to even greater market dominance, higher market share and even higher profits and free
cash flow over the long run.

Once they complete their investment cycle in 1-2 years, their profits and free cash flow will
revert back up to their high levels again. By that time, their share prices will be selling at high
premiums once again.

In the meantime, Mr market’s short term focus on current profits have caused these 3 stocks
to sell at ridiculously low prices. In my opinion, they are great businesses that are extremely
undervalued. I have shared my detailed research into these 3 stocks in the following videos.
Do watch them.

META Analysis Part 1 https://youtu.be/e4rk7GybxaE

META Analysis Part 2 https://youtu.be/HtfsCRrxznM
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Amazon Analysis Part 1 https://youtu.be/-0SfpPnsvcQ

Amazon Analysis Part 2 https://youtu.be/6DCaKXDq9IE

Adobe Analysis https://youtu.be/XmOih_sqqEI

Yes, I may look like a fool now holding these stocks that show big percentage declines.
However, I am taking advantage of Mr market’s short sightedness and manic depressive
nature to slowly accumulate a bigger and bigger stake at higher discounts. When sentiment
changes and their profits and free cash flow normalise, I can see 2X to 4X returns from these
investments.

Four Questions to Ask When Your Stock Falls in Price

As a new investor, it can be unnerving to see the price of your stock fall significantly below
your purchase price. It is natural to lose confidence in yourself and the stock when you only
focus on the short-term price movements.

Instead, you need to focus on the financial performance of the underlying business in order to
decide if it remains a great investment.

Here are four questions I constantly ask myself about a stock I own

a) Does the business continue to maintain its competitive advantage (economic moat)? Is the
moat getting stronger?
b) Are revenues growing and is the business profitable?
c) Does the business have a high average return on capital (ROE, ROIC)
d) Does the business have a strong balance sheet?

If the answer is ‘yes’ to the 4 questions, I know that the underlying business remains great.
Any fall in market price is an opportunity to accumulate more shares at bigger discounts. If I
already have a full position in my portfolio or have run out of cash to buy, I simply ignore the
short-term volatility and focus on the fact that prices will eventually be much higher in the
future.

However, if the answer is ‘no’ to the 4 questions, it means that the underlying business has
deteriorated. When this happens, I will be the first to sell the stock and re-invest the proceeds
into a fundamentally great business.
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The Bear Market Enters its 11th Month

Many investors have been asking me when this bear market would come to an end. I wish I
could tell you the answer to that but your guess is as good as mine.

What I can tell you with 100% confidence is that every bear market will come to an end (so
will this one), and will be followed by the next bull market.

Since the S&P 500 started in 1956, there have been 15 bear markets. They have averaged a
decline of -29.8% (median decline of -24.6%). The average bear market has lasted 11 months
(median duration 7.2 months).

As of today, we entering the 11th month of the 2022 bear market (with a drawdown of 27.5%
to date), so the Great Wall Street Sale is much nearer the end than the beginning. Continue to
hang in there and take advantage of this crisis while it lasts.

Our annual Black Market event is coming up 18-23 November PST. Do register to get your
free ticket to this learning-packed event where our courses and playbooks will also be offered
at fire sale prices!

May the markets be with you!

Adam Khoo
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