With heightened volatility and uncertainly, we want to provide a brief update on the markets and some context/frameworks that we find useful in navigating the rapidly changing investment landscape.
“There's no such thing as a good idea or bad idea in the investment world. It's a good idea at a price, it's a bad idea at a price.”
-Howard Marks
While attempting to call a market bottom is a foolish exercise, the increasingly bleak economic data and forecasts have, at least in part, been priced into certain sectors/industries/businesses and some high-quality assets have reached valuations not seen in years. We have an opportunity in the coming weeks/months to take advantage of these attractive entry points in both the public and private equity markets. And while a number top investment managers echo these sentiments, perhaps most notably is Warren Buffet – After net sales of $7B in 2020 & 2021, he purchased over $50B of equities in Q1 (net increase of $41B).
As a reminder and before examining the existing market and economic picture, our core investment tenants remain as pertinent today as ever. To name a few:
- Investing should be done with a long-term/multi-year/multi-cycle outlook.
- Volatility presents opportunity.
- It generally pays to be contrarian.
- Valuation always matters.
- Value & growth are joined at the hip and must be examined together with each and every investment.
With the S&P down nearly 20% from the early January high (-15% YTD) and the Nasdaq 27% off the high (-25% YTD), the market is attempting to discount a combination of negative outcomes, including a slowdown in corporate earnings, persistent and increasing inflation, continued rate hikes, and heightened geopolitical risks. Global supply chains remain disrupted, labor markets continue to tighten, the consumer is getting squeezed, and the war overseas seemingly has no end in sight. GDP growth in Q1 was negative (-1.5%) for the 1st time since the pandemic (prior to 2020 annual GDP hadn’t contracted since 08/09) and inflation (CPI) hit a 41-year high of 8.5% in March.
Here is a quick look at some equity and fixed income asset class returns YTD:
While the more growth-oriented sectors and industries have been hit the hardest, the sell-off has extended to nearly every segment of the market, apart from the oil & gas sector (+50% YTD). Prior to this year's gain, this sector had been decade long underperformer. Traditional diversification hasn’t helped – A 60/40 portfolio is -13%, Municipal Bonds are -8%, Corporate Bonds are -12% – nor have historically inversely correlated asset classes like longer-dated Treasuries (-20% YTD). Even Treasury Inflation Protected Securities (TIPS), which should be one of the better fixed income sectors amidst rising inflation, are down over -6%.
Blue-Chip US businesses and prior market darlings have participated and, in some cases, led the move down. These include Amazon (-33% YTD), Facebook (-43% YTD), Google (-25% YTD), Microsoft (-25% YTD), Apple (-20% YTD), JP Morgan (-25% YTD), Bank of America (-24% YTD), Disney (-33% YTD), and Home Depot (-30% YTD) – To name a few. These are all companies that we have owned for years in our core growth and value strategies and, until now, have treated our clients very well. There has been even more carnage in the cloud/software/internet companies that rallied significantly coming out of the pandemic – NFLX (-72% YTD), PYPL (-73% YTD), Zoom (-72% YTD), SHOP (-80% YTD), SNOW (-67% YTD). We could go on with this list…
The aforementioned dismal economic and market data is acutely understood by market participants and perhaps interesting historical context. But as we often discuss, the statistics and narrative of the past means little going forward. The stock market always looks ahead and discounts probabilities of future outcomes. This is a fact.
The ominous picture today is the reason markets have tumbled. To act on this knowledge after the fact is a guaranteed way to hurt your portfolio’s future performance. Our job, and that of any investment professional, remains the same – To constantly, consistently, and rigorously assess whether current valuations accurately reflect the future risk/reward.
Consider the chart below of the S&P (yellow), Earnings-per-share (white), and forward 12-month estimated earnings per share (green):
The circled area (2020) is an anecdotal example but something that is consistent with market declines and subsequent recoveries. The market climbs the proverbial "wall of worry" and rallies well before profits and forward estimate revisions. In fact, in 2020 the markets started to recover even before there was a meaningful decline in earnings and had recouped all of the losses before earnings even started to improve. The bad news had been digested well in advance of the print and left those waiting for the “coast to clear” with an even harder decision – When to get back in.
What does this picture look like today?
S&P (white) is charted against the Citi Earnings Revisions Index (yellow and then green bar charts). We see that forward earnings estimates have, as expected, started to turn down. While continued negative revisions could put downward pressure on the market, we know that this is in part reflected in current valuations and that the market will not wait for estimates or earnings to bottom on the way up.
As we continue to assess the likely path forward, we put together the chart below as a framework for looking at market, economic, and interest rate cycles.
Our poor artistic ability aside, this general framework informs a couple things. Note that the market is always ahead of economic growth and interest rate/Inflation cycles and that while a bull run can be long and gradual, market declines are generally sharp and swift.
One of the things existing data can do is help inform our whereabouts in the various cycles. We know the following: the market is down (to what is technically defined as “bear-market” levels), GDP has turned negative, inflation/interest rates are on the rise, and energy/defensive sectors are outperforming. The highlighted blue/gray box gives a range of this area.
When it comes to inflation, the April figure of 8.3% was actually a tick down from March (8.5%) and economic forecasts suggest that we may be headed lower in the 2nd half of the year.
Given the large spike in in prices coming out of the pandemic (see gas prices up over 100% since 2020 or used car prices up 50% this year after 10+ yrs unchanged) and the self-correcting nature of higher inflation/higher rates (the oversimplified economic theory is that higher prices increase supply and slow demand which subsequently pushes prices back down), it is not inconceivable that inflation ticks down in the ensuing months.
To gauge interest rates’ path, Former Fed Chair Ben Bernanke suggests watching the TIPS spread - that is the difference between the 10-yr treasury yield and expected inflation (CPI). This can suggest a few things but shows the 10-yr yield has caught up to expected inflation and could signal a slowdown in rising interest rates.
Consumer confidence and manager cash allocations are a couple of metrics used to gauge investor sentiment – Both hit recent lows.
Historically, the market has rallied an average of +24% in the next 12 months following these confidence troughs. This is a classic contrarian indicator.
Insider buying, which hits its highest level since the pandemic is lows, is also correlated with market positive future stock performance.
Finally, there were a couple positive takeaways from last week's news and market action. On Wednesday, the Federal Reserve released the minutes from their last meeting, where they hinted at taking a less aggressive approach if “the rate of inflation and our economy start to slow.” On the heels of this news, we saw $26B of new money come into equities and 80% of transactions on the buy side (at the ask). In addition, High Yield Bonds, which are often ahead of the equity markets, had their largest price rally in over two years.
In summary, while volatility will likely persist and markets could certainly get worse before getting better, we are increasingly more optimistic about the risk/reward and valuations of certain segments and for most clients have been incrementally adding to these areas. This is not an easy thing to do in the face of an intimidating economic backdrop but something that we know, with history (oh, and Warren Buffett) as our guide, pays off over the long-term.
Feel free to contact us with any comments or thoughts. We look forward to reviewing your risk/reward objectives and our strategy with each of you.