Anyone Feel Like Hibernating?

This article has been excerpted and edited from our quarterly newsletter to clients dated November 20, 2023.

We believe that we’re all beneficiaries of significant global progress over time. Extreme poverty around the world has more than halved over the last 25 years. Less than 10% of the world lives in low-income countries (down from 85% 200 years ago, 50% about 60 years ago, and 20% just 25 years ago). Life expectancy is over 72 years globally, up from just 31 years 200 years ago and about 55 years 60 years ago, with no countries left at less than 50 years of age. Global literacy is way up, as are cancer survival rates, child immunization rates, girls in school, and women in the work force.

These are all massive shifts in the right direction; however, we still endure clear periods of setback, whether political, social, or economic. While politicians should be more centrist, gravitating toward most voters, there’s been a widening polarization, and a dearth of appealing nominated candidates. Covid walloped all of us socially. Online dating appears tough on young adults. Then there are more major issues such as climate change and gun violence. And more recently, the Ukraine-Russia and Israel-Hamas wars have displayed horrific violence, suffering, and inconceivable levels of discrimination. These circumstances make most want to hide away.

Economically, cycles are normal occurrences. Supply and demand fluctuate, excesses occur, central banks act—often overreact, causing a downturn.

Bears hibernate. And currently, from a stock market perspective, we’re bearish. Markets generally are overvalued, and the economy is likely to shrink before it trends higher once again.

While stock markets tend to be in a bull market, with a rising trend, over 70% of the time, the remainder is spent in a bear market. We believe the prevailing trend now is down. Our Economic Composite (TEC^TM) is pointing to a recession in the U.S. Most of Europe is already in one. And based on preliminary figures, Canada is likely to officially report its second consecutive negative GDP quarter—the definition of a recession.

The impact from higher interest rates takes time to filter through the system. Consumer spending, which represents nearly 70% of economic activity, is showing signs of weakness. This doesn’t auger well for the economy, especially with consumer sentiment already so low. While gas prices have fallen recently, grocery bills remain high, and rents too. Mortgage payments have jumped significantly in the last 18 months and are set to rise further as mortgages renew. Housing affordability is at its lowest since the early ’80s. Weakening consumer demand should also crimp corporate profits requiring job cuts, which in turn should further worsen demand.

Meanwhile, central banks will initially be hesitant to lower rates, fearful of rekindling inflation, even though every time short-term administered rates rose this quickly, a financial crisis ensued. A time to hibernate.

What Are We Hiding From?

The primary driver of our Economic Composite is the inversion of the yield curve, when 10-year rates are below 90-day T-bills, the duration of which is now the longest in over 40 years. And it’s now been 13 months since our Economic Composite warned of a U.S. recession. This is the 10th such signal since the mid ’60s. The historical average time from a signal to a recession’s onset was 10 months. Others appear complacent because a recession has yet to occur. However, it merely appears to be taking a bit longer for the economy to roll over due to the magnitude of fiscal and monetary stimulus during the pandemic, which strengthened corporations and consumers, and led to record-low unemployment rates.

Only recently have applications for unemployment benefits in the U.S. hit a two-year high. It’s becoming tougher to find a new job. The U.S. unemployment rate has started to lift too, rising from a low of 3.4% to 3.9%.

The Conference Board’s Leading Economic Indicators have dropped for 18 months consecutively. And its Expectations Index, which measures U.S. consumer confidence, has been below 80 for the last couple of months. Readings that low have historically signaled a recession within a year.

It’s no wonder expectations are low, with the typical monthly mortgage payment almost doubling over the last 2 years to about 40% of household income, and well up versus the average over the last 40 years of about 25%. In the ’80s, when affordability was also this poor, the average home cost about 3.5 times median income, whereas it’s about 6 times today. And while prices of new homes have increased, the average size of a new U.S. build in the last 5 years has fallen 10% to 2,420 square feet. Talk about shrinkflation. House prices should struggle though, which won’t help sentiment. We need lower interest rates, increased supply, and a period of price stability.

Commodity prices are declining, potentially forewarning of weakening demand. The CRB RIND (raw industrial commodity prices of economically sensitive commodities) has been falling since early 2022 and has made recent lows.

Inflation is finally dropping to healthier levels. Core inflation is still running about 4% in the U.S.; however, if shelter is excluded, which falls more slowly since, amongst other things, rents are contractual, inflation would be running below the Fed’s 2% target. This is a result of central bank tightening, designed to quell inflation. The U.S. money supply has contracted for each of the last 10 months, something not seen since the Depression. These tight conditions have a lagged effect but ultimately lead to economic contraction.

Global trade is already declining. Internationally, both exports and imports have declined.

Overindebtedness

U.S. 10-year government interest rates recently ran up to 5% nonetheless, because the recession has yet to hit, central bankers have been holding firm that rates are to remain high for some time, and the massive issuance of bonds to fund deficits requires higher rates to attract buyers. The U.S. federal government needs to borrow close to a trillion dollars over the next several months, which could continue to pressure rates in the short term as supply of bond issuance remains high.

Record debt levels are now pervasive. Individuals, corporations, and governments all took on too much debt when interest rates were historically low.

With high debt loads and higher debt carrying costs, consumers are now forced to watch their pocketbooks—to lower spending and trade down. House prices have remained high despite their lack of affordability primarily because of the shortage of housing—inventory of houses for sale remains at historical lows.

Because affordability for cars is poor too, the average selling price for vehicles is down 3% this year, with EVs dropping about 15%. That’s to meet weak demand, during a period when Internet searches for “how to give back your car” exceeds that of the Great Recession. Consumers’ savings have waned. Real wage increases (after inflation) have been muted. Therefore, we’ve seen unions gaining power and plenty of strikes. That can’t help corporate profit margins.

Companies are now stuck with higher borrowing costs too and tighter credit standards. Loan delinquencies are rising. Tighter credit standards have always caused a recession when banks have tightened credit to the levels they have already. Commercial and industrial loans are no longer growing. Small businesses’ average interest rates have leapt from a low of 4% in 2020 to double digits, high levels not seen since just prior to the 2001 recession. Many corporations are unprofitable and reliant on debt issuance to refinance the billions of dollars of debt maturing over the next couple of years, at a time when lenders are already less willing to lend.

Government spending, at all levels, is out of control. Federal budget deficits are rarely this high relative to GDP, other than during wars or recessions, and are adding to overall debt. Additional debt from increased spending, as stimulus during a recession, would at least temporarily further worsen government debt levels. Problems facing other foreign jurisdictions may force them to react sooner. Some countries have already begun cutting rates.

A recession is likely and economic growth thereafter should be on the low side since debt levels this high, relative to GDP, stifle growth. Though, lower growth would likely result in muted inflation. We expect other secular disinflationary forces to be evident too. Slower population growth, globalization, and technological advances all contribute to keeping prices low. This should eventually have the benefit of keeping a lid on interest rates.

Taking Stock

Astonishingly, at a glance, the major stock market indexes appear to have ignored all of this. For example, the S&P 500 and Nasdaq have advanced significantly this year. Though, these advances are partly just a recovery from poor showings in 2022 and have been driven mainly by a small number of stocks that have boosted the major indexes. Just 7 mega-cap stocks are about 30% of the S&P 500 total capitalization, an all-time concentration high. And the 25 largest stocks represent about half of the index compared to about one-third 10 years prior.

For better context, and to illustrate what we believe is a bear market, major indices’ declines have been as follows, from their highs over the last few years (in local currencies): S&P 500 -6% (and was -26% in 2022); Nasdaq 100 -6% (was -35% in 2022); S&P/TSX -9% (was -18% in 2022); Value Line Geometric (1700 North American stocks equal weighted) -23%; Russell 2000 -27%; and TSX Venture -84% (its high was in 2007).

U.S. small caps have experienced over 500 days without a new high, nearing the last 40-year record of 568 days set in the 2008/09 meltdown.

As of the end of September, the S&P 500 had been flat for 2 years. In the last 50 years, that circumstance preceded all U.S. recessions, with a lead time averaging just 6 months.

Next-twelve-month earnings expectations for the Nasdaq 100 are up 18% in 2023, after declining 16%, peak to trough in 2022. That explains some of the gyrations. In contrast, earnings expectations for the average large-cap stock (equal weighting the largest 1,000 U.S. companies) are down 9% from a high one year ago and unchanged over the last 2 years. Small cap (Russell 2000) earnings are down 16% from mid 2022 highs. Other than the largest tech stocks, earnings have been flat to down, before the impact of a recession.

Generally, there’s a direct correlation between earnings growth and stock market returns, at least over time. We’re concerned that the economic headwinds will hamper earnings and, in turn, share prices.

Nasdaq relative performance versus small caps is at a high, and these tech stocks also trade at a near-record premium to the average large-cap stock. This bodes well for outperformance of the average stock versus the market-cap weighted averages. The Magnificent Seven trade at 30x next year’s earnings versus the S&P 500 equal-weighted index which trades at 15x, a much more palatable valuation, though still arguably fair value, based on today’s interest rates.

Our FMVs for the major markets are below prevailing prices. Corporations don’t see good value either. Insider buying of U.S. and Canadian companies has been muted. And corporate buyback plans have waned substantially, with only 150 S&P 500 companies buying back shares recently, down from 350 in late 2021.

Household allocations to stocks are still too high. Bear markets typically end with capitulation—investors throwing in the towel and indiscriminately selling shares.

Meanwhile, the major U.S. market indexes have run back up to TRAC^TM ceilings, after giving sell signals recently, enhancing the vulnerability and probability of declines to floors.

OUR STRATEGY

Consumer spending is showing signs of weakness, unemployment is rising, and sentiment is poor. Our TEC^TM has alerted us to a U.S. recession which should now be imminent; therefore, we remain cautious. Debt levels are excessive and interest rates are high. Neither are positives for stock markets whose valuations remain full. We hold some cash and a short position as a partial hedge against market declines. Though we expect a recession, it may be a muted one, because further stimulus should ensue and unemployment remains relatively low historically, providing a cushion.

While we wait for the downturn to play out, we hold and continue to add undervalued positions with outlooks for satisfactory growth, noncyclical business lines, manageable balance sheets, and attractive returns on capital.

Looking Forward to Emerging

Animals hibernate for self preservation—to conserve energy during adverse conditions. But then they emerge, ready for the more bountiful period that awaits.

While we still see an economic setback ahead, and a commensurate market reaction, we expect markets to discount the pending recession, and then once again focus on recovery. In the meantime, we are hibernating—hedging portfolios (afraid of market declines) and buying undervalued, high-quality, recession-resistant companies below our estimated FMVs.

Value, which normally outperforms growth, has significantly underperformed for about 12 years. The setup now, with growth stocks so overvalued relative to value, should treat us value investors much better over the next few years.

Despite fewer births, our much longer lifespans are boosting the world population, which now exceeds 8 billion. And the progress that is being made for all of us on many levels is just hard to see right now through the murkiness of the short-term issues. However, like the animals that hibernate, we’re doing so purposefully, to emerge ready and energized for a brighter period ahead.