Up and Down

This article has been excerpted and edited from our quarterly newsletter to clients dated November 18, 2022.

And up and down. Like a toilet seat, yo-yo, a game of Snakes & Ladders, not straight up and down like an elevator, but more like the ups and downs of a rollercoaster—that’s how the financial markets have felt lately. Unusually volatile, reacting to headlines related to inflation, rising interest rates, declining corporate earnings, layoffs, Ukraine, and covid-shutdowns in China. Emotions have been pushing markets up and down, while underlying fundamentals worsen.

CAUTION STILL WARRANTED

Inflation remains too high in most developed nations. The recent U.S. CPI up 7.7% and core inflation up 6.3%. The ECB expects Germany’s inflation rate to stay above 7% next year.

The U.S. figures also showed food prices rising by nearly 11%, with much higher jumps for staples such as eggs, butter, flour, bread, and milk. These statistics must clearly have the attention of central bankers and politicians. In the U.S. midterm elections, voters cited inflation as their biggest concern.

Thankfully, inflation has likely peaked; however, there’s a long way for it to decline back to acceptable levels. In a concerted effort to suppress inflation, a record nearly 90% of central banks globally are boosting interest rates—an unprecedented level of global synchronization. The rate increases may slow but rates are still likely headed higher until inflation rates are meaningfully lower. It will require a recession in all likelihood to squash inflation back down to the central bankers declared 2% targets.

Regardless of whether inflation has taken hold because of supply constraints or excessive demand, from fiscal (government spending) and monetary stimulus (zero interest rates), the outcome is real, and unfortunately persistent. Its impact is being felt throughout the economy.

Companies such as Beyond Meat are beyond help with customers switching from more expensive plant-based products. Consumers are also trading down from pork and beef to chicken. One of our clients recently remarked that they’ve never seen so many Range Rovers and Mercedes at the local No Frills.

With hiring freezes and layoffs having started, job security should become a prevailing concern, further depressing consumer confidence, and in turn spending. The housing market is in decline, with high mortgage rates and a dearth of listings from reluctant sellers. Corporate lending is declining too as costs are high and lenders are nervous. Lending standards have tightened to a level that had historically led to a period of significant defaults.

A time to remain cautious and disciplined.

RECESSION AHEAD

Our Economic Composite, TEC^TM, just alerted us to a pending peak in the U.S. business cycle. The composite is most heavily weighted by the shape of the yield curve which officially inverted, with 90-day T-bills now yielding about 40 basis points more than 10-year Treasury bonds. TEC^TM is used to identify the peak in economic cycles. It alerted us in 2019 to the pending 2020 recession—and dating back to the 1960s (in our backtest) alerted us to all 8 previous recessions.

The U.S. Conference Board’s Leading Economic Indicators, which look at 10 different indicators, are also warning, since they have fallen by greater than 1%. Historically, a recession has always followed. Since the 1960s, in 3 instances, a recession was already underway. And one started within 11 months for the other 5 signals.

Many businesses are already encountering declining unit volumes, which so far have been offset by price increases. But volumes should worsen. This, along with excessive inventories, should result in deteriorating earnings. The only real alternative is cost cutting via layoffs which can create a vicious cycle. Unemployment should bottom soon. It usually does 2-3 months prior to a recession.

CATCH-22

While central banks could pause their tightening if the economy skids, they will not likely stimulate initially for fear of reigniting inflation that remains way too high, just about everywhere.

Many signposts are in place that inflation should abate. House prices are falling, rents normalizing, used car prices dropping, raw material prices dipping, and shipping rates coming back into line. However, these are also worrisome precursors of economic recession.

Earnings declines typically follow once interest rates have peaked. When earnings are falling, stock prices usually coincide. It’s difficult to buck that trend, and in fact, stock prices typically overshoot to the downside as investors tend to over-extrapolate.

We do not believe we’ve seen this bear market’s low yet. Inflation this high and unemployment this low has always resulted in a near-term recession. And the recession hasn’t even started. Earnings haven’t meaningfully deteriorated. Interest rates are still rising. And investors haven’t capitulated.

While bearish sentiment had been high recently, which likely contributed to the most recent rally, stock ownership hasn’t fallen even close to levels associated with prior major market lows. In fact, levels aren’t too far off the record high achieved in 2021, matching the old 2000 high. Ownership levels this high are highly correlated with poor index returns over the subsequent few years.

We are also concerned because recessions are often accompanied by liquidity events or credit crises. There are already quite a few emerging markets that have government 10-year bond yields at, or well above, 10%. And even in developed nations, government debts and deficits are out-of-sight high. Many companies are in precarious positions too, after taking on plenty of debt, which may not be easily refinanced in a much tighter credit environment.

OUR STRATEGY

Stock markets have rallied recently, despite more signs of economic weakness and unattractive valuations. The North American stock markets’ current valuation levels aren’t consistent with prevailing interest rates. Meaning only lower interest rates, which don’t appear likely in the short term, would justify today’s valuations. Furthermore, bond yields are rarely this favourable relative to the market’s dividend yield. Bonds finally offer competitive prospective returns versus stocks. Though real yields (after inflation) are still negative—both unusual and unattractive.

In our long-short accounts, we look to short about 20% when our TEC^TM has alerted us to a recession, and another approximately 20% when our TRIM^TM indicator, our relative indicator of momentum, a sophisticated moving average used to detect market panic, is breached to the downside. If fully invested on the long side, this would leave us 60% net exposed to the market. We are already close to our maximum hedge since TRIM^TM was breached first in many markets, and we anticipated a recession because TEC^TM was so close to triggering.

We may flex our short exposure (where we are hedged either through short where authorized or holding inverse-long ETFs) in an attempt to take advantage of the market volatility; however, we wish to remain hedged, because our macro outlook supersedes any concern about missing out on temporarily rising markets during this period of time. We are more comfortable with a reduced net exposure to the markets, i.e. not fully invested. We also may reduce our U.S. stock market hedges and switch to a Canadian or foreign market ETF, if we believe the risk/reward profile is more attractive.

In the meantime, we continue to hold and add positions in companies that we believe can withstand an economic downturn and be worth more post a recession. Businesses whose products or services are essential, balance sheets are clean or manageable, returns on capital are attractive, earnings are growing, and are priced well below our discounted-cash-flow-based Fair Market Values (FMVs).

We have tried to steer clear of overvalued companies, and where earnings are meaningfully deteriorating. Next-12-months’ earnings estimates for tech stocks have now fallen by about 8%. They typically don’t fall at all unless there is a recession. Since this would be precedent setting, additional earnings reductions are likely. Valuations have been really compressed for tech darlings. The major technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Netflix) are down on average about 50% from their highs. We own a couple of those names now, where we believe the business outlooks and valuations are compelling.

And while many have claimed that value investing has seen its demise, we continue to believe otherwise. Saying value investing is dead is to us like questioning gravity or common sense. While the market is not perfectly efficient, it is mostly so. Companies detach from their underlying intrinsic fair values for periods of time for many reasons—short-term sales or earnings hiccups, or concerns about the same, from sudden moves in interest rates, competitive threats, or outright misconceptions. Once these issues are clarified—assuming fundamentals remain unchecked or reassert themselves—for most large companies, stock prices tend to rally in reasonably short order to reflect a company’s value. In fact, lots of our errors have been ones of omission, not pouncing fast enough on companies disconnected from our FMV estimates, only to watch a rapid reversion take place from the sidelines.

UP OCCURS MORE OFTEN

Markets spend most of the time in an uptrend because periods of economic growth last much longer than contractions. And the uptrend tends to be relatively orderly compared to downturns which can be breathtakingly fast.

Our Economic Composite has warned of recession. Interest rates have likely still not peaked. Central bankers are warning of additional tightening to lower inflation considerably. A poor backdrop for investing. The adage, “Don’t fight the Fed” is apropos now. At the same time, market valuations are relatively high and individual compelling investment opportunities are slim, supporting our stance that better opportunities may await.

We look forward to our patience being rewarded. We won’t be shy about adding investments when the risk/reward setups are favourable. While we wait, we’ll continue to hold positions in undervalued high-quality investments that we believe should weather a storm.

The markets have endured more than their normal ebbs and flows, fits and starts. More outsized ups and downs may follow. We are doing our best to manage through this volatility and the expected down while we wait to enjoy the more prolonged up that ultimately follows.