Gnostic Large Cap Model Portfolio Return of 2.8% for the Quarter Ended 03/31/2021.

For the quarter ended March 31st, 2021, the DJIA produced a return of 7.9%. The S&P 500 produced a return of 5.8%. The NASDAQ composite produced a return of 1.8%. US M2 money supply grew by 2.7% for the quarter.

The model portfolio started the year with an NAV of $471.98 USD per share and ended the quarter with an NAV of $485.38 per share; a return of 2.8%. This was above US money supply growth (barely) and somewhat above the return of the NASDAQ, but well behind the returns posted by the DJIA and the S&P 500.

Periodic underperformance is expected when one does not invest to earn short term returns. Prompt remedial action on my acquisition of Novovax made the loss largely immaterial for the quarter, on the overall return. Absolute underperformance was more specifically driven by a fairly violent pullback in PayPal (down by 25.5% from the quarterly high).

The headline story for the quarter was of a sector rotation; money reportedly moved from non cyclical companies into economically sensitive investments. That might explain the disparity between the DJIA &S&P 500 returns vs the NASDAQ; then again it might not. Pat answers, such as sector rotation, endeavor to provide a tidy soundbite in an unruly market.

What seemed most evident was a start-of-year eagerness by investors to jump headlong into equities poised to benefit from the end of pandemic restrictions, based on an expectation of global vaccination success. A resumption of normalcy and what is assumed will be a purchase explosion, based upon pent-up demand in leisure sectors, resulted in a lot of froth. The market clearly overreached and some investors failed to account for the double whammy of rising interest rates and deferral of global vaccination success. Maybe the vaccine success will be global, but it isn’t just yet.

There is also a clear disagreement between two camps of investors in the consumer spending categories. Some are of the opinion that consumer spending will forever change as a result of Covid-19, while others feel that consumers might revert back to more traditional forms of retail. I do miss restaurant dining, but after more than a year of foregoing the experience, I have concluded that I ate far too many subpar meals in my past and will be more selective going forward; perhaps I’m not alone. It is too soon to declare a winner either way in the debate on a permanent change in consumption behaviors; what is missing in the conversation represents the middle ground where some of the rampant growth in online purchases abates (yet still grows) while conventional retail picks up somewhat, but does not recapture 100% of the former market share. If a middle ground is the reality, high growth retail categories would be undercut somewhat while conventional retailers don’t rebound as fast either.

Finally, far too many investors, both retail and institutional, were unprepared for the end of the free money cycle. Margin buyers specifically, both retail and institutional, got blindsided a bit in the quarter. They sold winners to maintain newish holdings. This more greatly impacted NASDAQ and non-cyclical stories, which, for many, have produced abnormal paper gains throughout the years.

It seems like an easy thing to peel off some shares of a “multi-bagger” during a period of volatility in order to average down, on to what one declares to be the “next big thing”. The question that comes about from selling off winners; is one reducing a holding of a clear secular trend, to participate in what one calls the next trend, but that in reality, may just be a fad?

Fads and trends can look quite similar from a distance; trends can be held for a very long duration; in contrast, fads MUST be traded. I do not know the exact ratio of shorter term fads to longer term secular trends in the equity world, but rest assured, there is a staggering differential. I don’t like trades; they tie up mental and physical capital that can be put to far better use with long term secular selections. I am disinclined to trade, therefore, fads aren’t for me.

A roaring inflation reallocation, both in and out of the equity markets, has been noted thus far in 2021. Businesses possessing hard tangible assets, such as real estate, at historic cost, are more likely than not to continue to receive a steady flow of funds from investors who will be hoping for corporate actions to unlock values. In periods of inflation, producers of goods typically hold a profit advantage over sellers of services. Global governments’ willingness to dole out borrowed monies during the pandemic has created a store of liquidity for consumers which may be used either towards personal balance sheet repair, purchases of goods or purchases of services. A good old fashioned inflationary move to tangible assets might be exacerbated by individual FOMO on homes, real estate and items that may be perceived as being more expensive to acquire in the future than in the present. This can only be stopped through the recovery of stimulus funds extended; taxes will almost certainly rise for the coming years.

Most investors under the age of 40 lack real world experience with valuation multiple tightening that is typically evident during periods of rising interest rates. Those among us who are older haven’t experienced meaningful tightening in over a decade. Lulled by complacency, we may have too easily forgotten the hard rowing upstream, during the period of 2005-2010, where rising interest rates led to a wholesale implosion of credit markets, with a multiyear repair process required thereafter. Some high quality non-cyclical stocks, during the period of 2000-2010 reported a full tripling of their profitability due to participation in secular trends, yet the shares barely budged during that decade.

Turning to the portfolio, there was a fundamental development to report during the quarter. A takeover has been announced of Kansas City Southern by Canadian Pacific. These are the two smallest of the class 1 railroad operators in North America. It is assumed that there is little regulatory opposition to block the deal.. While I am not fond of takeovers, this is structured for minimal tax consequences; the lions’ share of the purchase price will be paid for in stock, with a cash component of about 1/3 of the estimated total consideration. For CP, the transaction should be immediately accretive. Due to timing and potential for regulatory review, the shares of KSU have not yet touched the assumed takeover price.

In other news, a new CEO of UnitedHealth Group will be helming the ship for the balance of 2021. My opinion is that the newly promoted head of the Optum subsidiary will be seeking to bulk up UNH, presumably with a faster pace of acquisitions. I don’t anticipate meaningful acquisitions directly in US health insurers; rather, I assume that the emphasis will be on higher profit margin ancillary businesses that are the specialty of Optum.

The quarter ahead looks interesting; interesting doesn’t always indicate positive. A deceleration of money supply growth in the US compared to last year has been noted. A final round of economic stimulus has been passed, apparently largely unwarranted. Those sums will certainly be clawed back through higher taxation, and deservedly so. Those that were freely spending stimulus payments on consumption, or using stimulus payments as a source of margin capital for speculation on service based equities, might need to prepare for the selling of assets to return that money in the coming year. It could be a real shock to many, to learn first-hand, that economic growth and rising stock markets don’t necessarily go hand in hand, particularly when confronted by rising bond yields.

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