Lukewarm

Equity markets in the US are certainly not screaming buys, nor are they hot & ludicrously overpriced. If we had to pick a temperature, we’d go with “lukewarm”. That implies that we really need to be discerning about what we buy. This is what our Watch List is designed to do – to zoom into the best SWAN Investing candidates.

Our Watch List is built upon our Investability Ratings system, which assigns a rating to each investment candidate or index constituent (we also track some ETFs). The Investability Rating is a combination of two sub-ratings: Believability and Scalability. Here’s how it works:

1. High Investability Rating = High Believability AND High Scalability
2. Medium Investability Rating = Low Believability AND High Scalability
3. Low Investability Rating = Low Believability AND Low Scalability

The numerical nuances of these ratings are explained in detail here. But here’s the gist:

Think of these ratings not in terms of prospective returns, but in terms of prospective risk. And risk means permanently losing money by buying ludicrously overpriced assets. So, a High Investability Rating implies that the stock is reasonably priced or that the market is probably underpricing potential profit growth of the underlying business; a Medium Rating implies that it’s richly priced, but the underlying business has significant operating leverage built into it, which deserves a second look; a Low Rating implies that given the cost structure of the business (not scalable), the stock appears to be highly overpriced. Obviously, the meat of the analysis is subjective and beyond the scope of mechanical calculations based on numbers flowing in from a database. But the Investability Ratings do make our investment process much more efficient. At the very least, it steers us away from landmines.

In short, a “High” rating = Low Risk of losing money. A “Low” rating = High Risk of losing money.

We have our own curated Watch List, based on our Investment Themes. But we also maintain Watch Lists for the following:

1. S&P 500, excluding Financials and Airlines
2. S&P Select Healthcare Index ETF (Ticker: XLV)
3. First Trust Cybersecurity ETF (Ticker: CIBR)

Now, if someone asks us, “is the market overpriced?”, we go back and look at what percentage of the market is rated “High” – compared to both the long-term average and compared to other Watch Lists. We track the long-term averages separately. Compared to each other this is how our Watch Lists look:

The First Trust Cybersecurity ETF (CIBR) has the best numbers; most of the constituent stocks are rated “High”. We should point out that this number-crunching was only done on its top 25 constituents (out of 40). However, the top 25 make up more than 90% of the index if measured by weight.

The overall market, as represented by the S&P 500 (excl. Financials and Airlines) doesn’t look too good with only about 10% of its constituents rated “High”. However, this number is roughly unchanged since we’ve been tracking it (since late summer 2021). We’d be inclined to call the market overpriced if that number dips significantly below 10% to, say, 8%. As of now, we’re sticking with lukewarm – some exciting deals if you’re prepared to dig deep.

We do this sort of temperature-gauging for our Portfolio as well. In fact, we track XLV and CIBR because they happen to be two of our current holdings. Each of our holdings gets an Investability Rating. We’ll discuss our portfolio in the next section, followed by a closer look at the now topical Healthcare sector.