Leaven Partners Q3 2024 Letter To Partners

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Dear Partners,

In the third quarter of 2024, total fund assets declined by -1.4%. For the three-year period, the fund is up 15.3% ¹ compared to the S&P 500 (SP500, SPX) return of 38.5%.

On the heels of disappointing performance in the previous quarter, we experienced lackluster results in the third quarter. Robust performance in the first quarter has kept us in positive territory for the year. Our core holdings appreciated slightly in the quarter, contributing 1.5% to total gross returns, but woefully underperformed the benchmark equity indices.

Below the surface, our core holdings experienced a volatile ride in the quarter. On August 5 th, the Nikkei (NKY:IND) dropped 12% in one day! This was one of the steepest declines in the past 40 years. Over three days, Japanese equities were down approximately 20%. It is impossible to know for certain the cause of the sudden drop; the most accepted narrative is the unwinding of the yen carry trade that I referenced in my previous letter. The Bank of Japan hiked interest rates for the first time in 17 years, coupled with a weak U.S. July Jobs report, are the most likely catalysts for the surge in the Japanese yen. Sure, the Bank of Japan was dissatisfied with the increased instability in the public markets and responded by explicitly stating they would not raise rates further until stability returned. It appears their soothing language had a calming effect on the markets as things began to stabilize. Our Japanese holdings were not immune to the sudden downdraft. It was a quick ride down! In about 2 days, we saw most of our gains on the year evaporate. We spent the remaining quarter slowly clawing our way back into positive territory.

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Related to the surging yen, our foreign currency strategy made a negative contribution of -0.6% in the quarter, giving up some of the gains earned in the previous two quarters. We started the quarter short the yen, with the yen at around ¥161 to the dollar. The yen began its appreciation versus the dollar in July, accelerating in early August. We were pushed out of our short position on the yen at ¥155 near the end of July, as it hit our stop loss. The yen finished the quarter at around ¥143. Although we experienced a positive effect from being long the yen as it continued to appreciate in the quarter, it is not reflected in the performance of the FX Strategy-as it only calculates a performance return when we are short the yen. Overall, the strategy has been beneficial to the fund-not only in smoothing out returns from year to year but also in providing a bit of added profitability. I plan to continue to implement the strategy going forward. Although we were long the yen for the remainder of the quarter, we recently went short the yen as it devalued through a channel breakout and established a weakening trend.

On a more sobering note, the hedge strategy continued to have a negative impact on returns. This quarter, the frustration was particularly acute due to the sharp pullback in August, (causing volatility to spike to its highest levels since early COVID), and rapid bounce back to new highs. The hedging strategy is designed to provide protection during sustained market moves to the downside. It is not, however, designed to do well in choppy waters: big moves down with quick reversals to the upside. As luck would have it, we experienced extremely choppy waters in the quarter. Our hedge positions were triggered on as the market began to fall precipitously, only to soon be whipsawed back off as markets quickly reversed course. We covered our short positions at a loss. We had one lone short position, Invesco DB Oil Fund ETF (DBO), that we covered on a realized gain, that mildly offset our other realized losses. But the two workhorses of the strategy, the S&P 500 and the Nasdaq 100, both had material losses. We are currently not in any short positions under the hedging strategy.

By design, the hedge strategy is not structured to make money often. In fact, over longer periods it is nearly guaranteed to lose money. By implementing a trend-following approach, the hedging strategy is designed to have positive returns during sustained and prolonged market downturns. Without sustained and prolonged market downturns, the strategy is destined to lose money. As I have mentioned in prior letters, I do not intend to implement a hedge strategy, or tail-risk strategy, in the fund always. In fact, I assume that in most periods during the life of the fund, I will not use a hedging strategy.

It is perfectly plausible then to debate the efficacy of a strategy that is designed to lose money over time-particularly in light of the fact that we have lost money consistently on our hedging strategies since I implemented them in 2021.

It is well known that valuation alone cannot be used as a timing tool in the market in the short run. Although valuation has some predictive capabilities over longer periods, say 8 to 10 years, it does not hold up well under shorter periods. However, I do believe that valuation should always be used to aid one in providing reasonable future expectations-and, in rare cases, should sober one into taking pause.

In its simplest expression, valuations today are two standard deviations above their historical trend. Although a simple price-to-sales ratio (shown below) cannot predict near-term market movements, at two standard deviations above the norm, it should, at the least, urge us to pause.

The pause is warranted, in my opinion, because the last time ² we were at 2 standard deviations above trend, the S&P 500 went down nearly 50% and the Nasdaq 100 went down nearly 80%, giving up all of its gains during the bubble.

I continue to believe that reducing volatility in the fund is an objective worthy of attention. Gunning for the highest returns sounds great, but in order to finish first, first you must finish. Although it feels like driving with the brakes on, our hedging strategy is designed to help protect us from some of those catastrophic losses-that are not only emotionally painful but can take years to make up for the losses.

You may wonder why I am concerned when most of our money is overseas. First, (which is a bit anecdotal), our fund saw significant losses in the fourth quarter of 2018 during the quick market correction in the US leading to the “Fed pivot”-when it is quite logical to argue that the event should have had little to do with our holdings. And second, which is more important, as the global economy becomes more connected, it has been shown that the correlation of returns between markets has gone up over the recent decades. What was once a better source of diversification during times of idiosyncratic stress, is less so now. In other words, when the you-know-what hits the fan, equity markets around the world tend towards a correlation of one nowadays.

With the majority of my net worth in the fund, coupled with your hard-earned savings, I aim to steer through these precarious times as carefully as possible.

In Closing

I am grateful for your participation in Leaven Partners, and that you have entrusted me with managing your assets. I look forward to reporting to you at our next quarter-end.

In the meantime, if there is anything I can do for you, please do not hesitate to contact me.

Sincerely,

Brent Jackson, CFA

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