Up and Down
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.
Our Economic Composite, TECTM, 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. TECTM 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.
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.
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 TECTM has alerted us to a recession, and another approximately 20% when our TRIMTM 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 TRIMTM was breached first in many markets, and we anticipated a recession because TECTM 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.
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 among 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 Activision Blizzard, Intercontinental Exchange (after selling it on a runup last quarter), Microsoft, Comcast, and Warner Bros. Discovery. We sold Telus International and Cigna as they increased toward our FMV estimates, and Simon Property Group, Five Below, and Jumia Technologies when each broke down through floors.
Activision Blizzard is one of the largest third-party video game publishers in the world. Key properties include Call of Duty, Candy Crush, Overwatch, and World of Warcraft. Earlier this year, Microsoft announced plans to acquire Activision for $95 per share in an all-cash transaction valued at $69 billion. Microsoft’s surprise move was clearly opportunistic with Activision’s stock down 40% from its high, due to revelations of sexual harassment at the company. California’s Department of Fair Employment and Housing sued Activision in July 2021, alleging the company “fostered a sexist culture” where executives engaged in widespread inappropriate behaviour. Microsoft’s acquisition of Activision is being scrutinized by global regulators, and the wide gap between Activision’s price and Microsoft’s offer provides evidence that there is skepticism regarding the deal’s approval. At $75, we view shares offering a win-win set up—a sizeable discount to Microsoft’s $95 offer and our own $92 FMV estimate. There’s no doubt the share price will fall in the short term should the deal fail to win regulatory approval, but we see Activision well-positioned for long-term success. Furthermore, as numerous platforms seek scale and content, another suitor could emerge for Activision’s valuable global franchises.
Intercontinental Exchange (ICE) owns numerous exchanges, including the New York Stock Exchange, International Petroleum Exchange, New York Board of Trade, and the Chicago Stock Exchange. However, trading fees account for less than 10% of revenue; half of revenue is derived from its subscription-based data-analytics business. Investors are waiting to see if its acquisition of mortgage technology company Black Knight will be approved by regulators. Should the deal fail, we believe share price will rise as the acquisition is perceived to be expensive and an increase in the risk profile of the company. While the deal carries integration risk and its foray into the mortgage industry will take time to digest, we like the move as ICE’s management team has a clear history of revolutionizing data-centric industries. Our FMV estimate is $130.
Microsoft was also repurchased after its share price dropped during the general tech-led market correction. The company is seeing macro headwinds in its Azure cloud offering, Windows, and advertising. We expect near-term results will continue to be impacted by a weaker economic backdrop as its customers pause large-scale technology products and reduce employee headcounts. Longer term, we see Azure growing in the high teens and the rest of its products and solutions benefiting from the digitization of business. Our FMV estimate is $300.
Comcast share price fell nearly 50% from its high. It has been reeling, along with cable and media peers, impacted by customers who’ve readjusted their demand for Internet and mobile data from peak levels seen during the height of the pandemic. In Q2, Comcast lost 28,000 broadband customers and gained just 14,000 in Q3. However, we believe overly-pessimistic expectations about long-term subscriber growth are factored into the shares price. We believe Comcast’s cable business has several competitive advantages over competitors AT&T and Verizon, and we expect the company’s market share gains to continue. Meanwhile, several growth avenues around its steady cable business, such as wireless and business services, are long-term opportunities that appear to be unappreciated. Our FMV estimate is $40.
Warner Bros. Discovery was formed when AT&T merged its WarnerMedia unit with Discovery earlier this year. The combined entity is one of the largest media companies in the world, spanning TV (HBO, Discovery), movie studios (Warner Brothers), cable networks, news (CNN), animation, direct-to-consumer streaming, sports, and unscripted content. After a couple of quarters as a combined company, results have been mixed and murky. However, it largely reflects decisions made by prior management, not the strategic direction outlined by the new team headed by CEO David Zaslav. While under AT&T’s control, the assets floundered, and capital was poorly allocated. The hard work of reviving and uniting the portfolio of brands and streaming services is just beginning. The hiring of Peter Safran and James Gunn to craft a multi-year vision for the company’s DC properties (e.g., Batman, Superman, Justice League) is a sign of how serious management is about rejuvenating its properties. Management’s key strategic priorities are the roll-out of its new streaming platform that will unite HBO Max and Discovery+ and new ad-supported streaming services. Once the new streaming services launch and fresh high-quality content arrives, the company’s value should become more evident. We expect near-term results to continue to be bumpy—and now management will need to navigate a weaker ad market, as well as a levered balance sheet, while turning the company around. Our estimate of FMV is $25.
Just like with the stock market, U.S. high-yield corporate bonds (ICE BofA Index), now yielding 8.6%, have bounced around too. Yields were recently as high as 9.5%, more than twice the year-ago levels, and could rise further if government yields continue to increase, defaults rise, or spreads versus government bonds widen even further. 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 6.8%, and most of our income holdings—bonds, preferred shares, REITs, and income funds—trade below our FMV estimates.
We acquired no new positions in the last few months, other than adding to our position in the German juggernaut apartment owner Vonovia, since it declined from our original purchase price, despite no apparent material change in its fundamentals. And we sold some positions that appeared to be at risk of decline, either because they reached our FMV estimates or appeared susceptible to market disdain. We continue to invest with an additional level of caution because of our macro concerns and a lack of attractive individual opportunities.
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.
Randall Abramson, CFA
Generation PMCA Corp.
November 18, 2022
All investments involve risk, including loss of principal. This document provides information not intended to meet objectives or suitability requirements of any specific individual. This information is provided for educational or discussion purposes only and should not be considered investment advice or a solicitation to buy or sell securities. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.