Depressing the Optimists
We normally start our letters on a positive note. Not necessarily because it’s our style or our nature (though that is the case) but because it usually pays to be optimistic. Markets rise over longer periods of time, and most of the time is spent on the upswing. However, though we are devout optimists, we are also realists. And over the last few months, there’s been cause to get real.
The economy took off after the initial lockdowns in 2020. Loose monetary and fiscal policies ignited growth and have resulted in unwanted inflation, just about everywhere.
From the onset of the pandemic until the end of last year, the U.S. money supply grew by 18% annually. And inflation, after a period, began growing by double digits too. This excess money remains in the system, and it will take some time for it to be properly absorbed.
Aggregate demand is now naturally slackening, and in response to inflation, central banks have tightened considerably, resulting in a reversal of the economic picture. The money supply has now stopped growing, which should arrest economic growth.
Stuck in Reverse
Home sales are way down with mortgage rates way up. Price declines should follow. Over 60% of Americans don’t have sufficient savings and live paycheck to paycheck, average bank balances have declined; rents have jumped; phone bills are going unpaid at higher rates; vehicle repossessions are up markedly; credit card debt is way up; buy-now-pay-later plans are everywhere, and consumers will struggle to meet obligations if interest rates rise further. Meanwhile, consumers have shifted noticeably away from durables—e.g., autos (used car prices are now falling) and patio furniture—toward staples.
Companies are beginning to feel the impact. With demand shrinking and customers delaying bill payments, hiring freezes and job cuts are beginning; though unemployment, at the lowest in 50 years, has yet to budge.
Measures of industrial production are falling, and leading economic indicators are negative. Yield curves are inverting. Our own Economic Composite (TEC TM) recently alerted us to a recession in Canada and Germany. The U.S. and UK are close to signaling too. Despite ultra-low unemployment, the U.S. has already suffered 2 consecutive quarters of declining GDP. Further weakness is expected since central banks are likely to continue to tighten, even though general monetary conditions are already tighter in the U.S. than at any point in the last 25 years. We expect higher interest rates, less money printing, and government spending to also slow further. After overdoing it, they are now undoing it—suppressing growth to lower inflation. Look for unemployment to bottom, which usually occurs 2-3 months prior to a recession
The monetary authorities have been outspoken about their desire to quash inflation at the expense of employment—the Bank of England even warning of a recession later this year.
We haven’t just seen rising prices but also shrinkflation—smaller amounts in the same package. Everything is shrinking—fewer tissues in a Kleenex box, not as many perks for the same price at hotels, smaller Gatorade bottles, not as many potato chips in a bag, and even our quarterly letter is a couple of pages shorter
Thus far, corporations have been able to use these measures along with price increases, which could continue since it’s the only alternative to offset declining volumes and higher input costs. But volumes are already declining. And rising costs can’t be reduced without layoffs because commodity prices aren’t negotiable; wages aren’t easily reduced given the immediate shortage of available employees; interest rates are rising which hurts an historically leveraged corporate America; the USD is strong which degrades foreign earnings, and suppliers can’t be squeezed when just having supply has been a luxury. Some companies stockpiled and are stuck with too much inventory.
Only now are we beginning to see layoffs as cost cutting measures. An increase in unemployment will further impact an already apprehensive consumer. Corporate profits should contract as price increases are limited when demand weakens.
Productivity has also suffered. The U.S. just experienced the largest quarterly productivity decline since 1947. Hard to figure why this is occurring other than to cite anecdotal evidence such as impacts from work-from-home, Covid illnesses, and the lack of suitable employees. It’s no wonder we all know someone who’s recently lost baggage.
Is Everyone Else Depressed?
The stock and bond markets both reacted negatively in anticipation of economic weakness. Stock markets fell back to multi-year average valuation levels. There was a bear market in just about everything. In the last few weeks, there’s been a big bounce; however, since pessimism was so pronounced in late June, we believe it’s simply been an oversold rally—a temporary imbalance of demand for shares in excess of supply.
It’s hard to believe this bear market will have bottomed with a forward multiple of 20x for the Nasdaq. Or that the markets will press higher from today’s valuations, close to the average highs of the last 10 years, despite today’s higher inflation and interest rates which should suppress valuations.
Corporate profits remain vulnerable. S&P 500 earnings estimates usually fall 14% in a recession. So far, the market has declined based on a contraction of valuation multiples since forward earnings estimates have barely moved. But estimates have flatlined. Expected 12-month earnings for the MSCI All World Index haven’t grown in 6 months, despite deceptively high revenue growth assisted by inflated prices. Meanwhile, declining values of everything have had a negative wealth effect. And credit conditions should tighten too as bankers get nervous.
We haven’t even mentioned potential worsening of geopolitical issues with Russia or China.
But we also need to factor in everyone else’s pessimism. Most now expect a recession. That means we should be in a bottoming process. Though, the signs we see at market bottoms are still not visible nor were they in June when the market recently bottomed. If today’s low expectations are exceeded, markets may rally. When sentiment is so poor, even bad news is treated as good news since news is not as bad as expected. More likely, in the short term, such negative sentiment may weigh heavily on consumers already buying fewer items and having to pay more for them. Affordability issues are influencing aggregate demand.
We’re Optimistic About Our Pessimism
Nearly all our indicators are lined up and pointing to lower stock market prices. It's not just TEC TM, which has already warned of recession in some countries, that concerns us. TRIMTM, an indicator of momentum, our “market panic” tool, has also negatively triggered in most markets. Like our Economic Composite, it was designed to pick up these rare occasions.
Technically, stock markets look toppy again too. Most key indexes (S&P 500, Nasdaq, the DOW, and TSX) are back to price-to-book ceilings in our TRACTM work, which we use to gauge changing investor sentiment. Some have remained on sell, already having broken down and merely recovering recently to ceilings, providing an earlier indication of potential upcoming negative inflections.
Interest rates are rising. The central banks are forewarning that the short-term administered rates will continue to rise until inflation is back to 2%. Longer-term rates are moving higher again too. This is not positive for near-term asset price valuations.
This year has endured an extreme number of up or down 1% daily moves in the S&P 500. However, in the recent rally, the volatility index has dropped significantly, to a point where the market usually tops.
The Canadian dollar has given us a TRACTM sell signal. This usually coincides with a recession. And we expect the CAD to decline below $0.69 in USD terms.
China’s growth has been weak. Partially because of its zero-Covid policies, which to us make absolutely no sense. Though China’s inflation rate is only just above 2%, so maybe there’s a perverse method to its madness. The country’s property and debt problems are concerning too (they just lowered interest rates). If China’s growth falters, it could affect global growth.
Commodity prices have been weak. While a positive for the inflation outlook, it’s a negative indicator for economic growth, especially since industrial commodity prices have abruptly declined after propelling to lofty heights.
Since corporate earnings have generally held up, the economy and stock market are taking time to roll over. We expected a much worse showing in Q2. Expected next 12 months’ earnings for technology stocks have only declined 4%. Outside of a recession, expectations for tech stocks earnings only fell once in the last 30 years, by a similar amount in late 2018. Further reductions appear likely. Consumer Discretionary stocks’ expected earnings are off 9%. Yet this group trades at what appears to be an unsustainably high 24x forward estimates.
We still don’t see enough investment opportunities from a bottom-up perspective. The lack of attractive high-quality opportunities always negatively influences our outlook.
Even if we don’t encounter recessions across the globe, slower growth for some time is likely. Especially since central banks are not able to accommodate economic growth when they’re busy tightening to combat inflation. This too implies lower returns.
Despite all this, valuations remain stubbornly high. Bear markets normally witness widespread selling resulting in households reducing exposure to stocks. This has yet to occur. We believe a selling capitulation remains ahead. Clearly, in our view, a time to remain cautious.
Looking For Silver Linings
In case you thought we weren’t still capable of seeing the bright side:
We don’t expect a deep recession. Though reducing inflation to 2% or below may take some time, inflation appears to have peaked, and recessions always squash inflation. Supply chain issues are ameliorating, oil prices have fallen considerably from their highs which helps at the gas pumps, and commodity price declines should arrest food price hikes too.
Longer term, inflation should be restrained because economic growth should be below average due to poor demographics, heavy government debt burdens, and less central banks stimulus given that the recent experience brought nasty side effects. As a result, the next up-cycle could be an extended period of expansion.
Despite the recent unhealthy productivity figures, we are still undergoing a technological revolution. Not only should that also assist with keeping prices in check over time, it should also help drive economic growth through continued innovation.
Interest rates, in turn, should eventually be relatively low too—though don’t count on zero again any time soon. And that should set the table for above average valuation levels. While market valuations are not attractive yet, they are no longer in overvalued bubble-territory.
Seasonally, in the period ahead post the November elections, the S&P 500 has lifted by an average annualized 21%, without a single decline since 1900.
Our market hedges have helped protect us through this bear market. So far, we’ve chosen to hedge via the U.S. stock market (either short where authorized or with an inverse-long ETF). We may switch some of our hedge to include a Canadian or foreign market ETF, where we already have signals from our Economic Composite, or subindexes, such as Consumer Discretionary, if we find the risk/reward profile to be more favourable.
Though we considered reducing our hedges somewhat with the S&P 500 at a TRACTM floor at the recent market bottom in June, too many other signals, including our macro tools, kept us from covering.
Our multi-pronged risk-management approach, which also considers market momentum and valuation, has kept us negative, especially considering the recession signals which weren’t yet evident when we drafted our last letter.
We continue to hold, and seek out additional opportunities in, undervalued highest-quality companies with potential catalysts to close gaps between prices and our Fair Market Value (FMV) estimates. Any further market weakness would be desirable to redeploy funds into additional investments.
When the Canadian dollar rallied recently along with the markets, since it had previously registered a sell signal, we materially reduced our USD hedges for Canadian clients. Most of our investments are in USD-based securities, and we stand to benefit in CAD terms if the CAD exchange rate falters.
The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios—Recent Developments for Key Holdings
All Cap portfolios combine selections from our large cap strategy (Global Insight) with our small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. The smaller cap positions tend to be less liquid holdings which are more volatile; however, we may hold these positions where they are cheaper, trading at relatively greater discounts to our FMV estimates, making their risk/reward profiles favourable. There were no material changes in our smaller cap holdings recently.
All Cap Portfolios—Changes
We made changes within our large cap positions summarized in the Global Insight section below.
Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. At an average of about 60 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear much cheaper, in aggregate, than the overall market.
Global Insight (Large Cap) Portfolios—Changes
In the last few months, we made several changes in our large cap positions. We bought Citigroup, The Cooper Companies, Medtronic, and International Exchange. We sold Total as it achieved our FMV estimate, and Microsoft, Disney, Microchip Technology and US Bancorp when each broke down through floors.
Citigroup is undergoing a dramatic transformation, shedding its consumer banking businesses in numerous markets around the world. Management has refocused on commercial banking and capital markets operations where it can leverage its global scale, the company’s key competitive advantage. Operating in virtually every key market around the world, Citigroup is unmatched for large, complex cross-border deals. We expect this shift to create a simpler, more focused bank that will generate higher returns on equity and earnings growth. Though higher interest rates are beneficial to its profitability, with economic growth slowing we expect Citigroup’s loss provisions could escalate and M&A advisory business should slow. Our estimated FMV is $70.
The Cooper Companies is one of the world’s largest manufacturers of contact lenses. Cooper, with a 25% market share, controls the soft contacts market with rivals Johnson & Johnson, Bausch & Lomb, and Alcon. This powerful oligopoly, in addition to strict industry regulations and advanced manufacturing know-how, provides pricing support and high barriers to entry. Cooper’s lenses have gained market share against its competitors over the last few years and continue to post industry-leading growth. International markets should provide a long growth runway as adoption of contact lenses rises worldwide. CooperSurgical, the company’s fertility segment, has experienced lower sales due to the pandemic—telemedicine has shifted patients towards birth control instead of IUDs which require visiting doctors. A key risk is stricter COVID lockdowns in China which would further disrupt its supply chain. Our FMV estimate is $390.
Medtronic is a global medical technology company. Its diverse portfolio of products covers cardiovascular solutions (pacemakers, stents, valves), surgical robotics, neuroscience (brain modulation, spinal cord stimulation), and diabetes sensors and pumps. The global pandemic reduced hospital capacity and postponed procedures, hurting demand for Medtronic’s suite of products. Volumes in most markets are now back to pre-COVID levels. However, a new headwind, supply chain issues in China, hurt the company’s most recent quarterly results. Moving forward, we anticipate earnings growth at a mid-single digit rate as emerging markets also adopt Medtronic’s solutions. Our estimated FMV is $130.
Intercontinental Exchange (ICE) is well-known for its ownership of numerous exchanges, including the New York Stock Exchange, International Petroleum Exchange, New York Board of Trade, and the Chicago Stock Exchange. A series of data-analytics acquisitions has repositioned ICE as a dominant market data and technology solutions company. In fact, NYSE stock and equity trading fees account for less than 10% of revenue while over 50% of revenue is now derived from recurring data-services. The company is aggressively moving into mortgage technology with the aim of lowering origination costs via increased automation and transparency. Its proposed $13 billion acquisition of Black Knight, a provider of mortgage software and data analytics solutions, would significantly boost these efforts. Though, this carries integration risk and exposes the company to real estate and housing at a time of rapidly rising interest rates. Still, we believe the mortgage industry is ripe for disruption and the company’s historical M&A success gives us confidence in ICE’s ability to integrate smoothly. Our FMV estimate is $130.
High-yield corporate bond yields peaked recently at 9%, more than double the all-time low from a year ago. The yield is 7.3% now, but it is susceptible to rising further if rates rise generally, defaults escalate, or spreads to safer government bonds widen. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 5.3%, and most of our income holdings—bonds, preferred shares, REITs, and income funds—trade below our FMV estimates. Similar to the equity side, we are not finding many attractive opportunities on the income side, both from a bottom-up basis—fewer quality opportunities—and because our top-down tools are suggesting an additional level of caution.
We recently sold VICI Properties after it reached our target, and FS KKR Capital and Oaktree Specialty Lending when each broke below TRACTM floors. We also purchased Vonovia and BSR REIT, both owners of apartment buildings. Vonovia is the largest apartment real estate company in Europe with most of its assets in Germany. Its shares yield 5.3% and trade at a 40% discount to our FMV estimate. BSR REIT is a Canadian REIT with buildings primarily in Texas. At purchase, it traded at a 3.4% yield and a 35% discount to our FMV estimate. Both had declined in response to increasing interest rates, despite enviable track records of net asset value growth. Our valuation estimates incorporate somewhat higher interest rates.
Our glass is typically half full. Lately, the contents have been evaporating. What would fill it again? Either a substantial market decline lowering valuations, or a sudden reduction in core inflation levels along with a commensurate decline in interest rates. Neither are likely to occur in the short term. Though valuations have compressed from their highs, further deterioration is expected as the economic backdrop worsens.
We'd like nothing better than to reverse our negative stance. But we can't get there yet. Therefore, we will need to continue to be patient. As always, we hold positions that we believe are undervalued high-quality investments and seek out additional opportunities to deploy capital where prices are sufficiently below our estimates of fair value.
Being an optimistic investor pays off over time. It’s also been shown that optimism helps with one’s physical and mental health—with resiliency, immunity, and longevity. So, while our tools have us in a pessimistic stance, we’ll keep our chins up, our eyes peeled for the light at the end of the tunnel, make lemonade from lemons where we can, and hang in there until our tools indicate that the glass is at least half full again.
Randall Abramson, CFA Generation PMCA Corp. August 19, 2022