Market Thoughts Following Q1

Introduction

The markets are in a volatile and dangerous place as of now. As a hedge fund, it is our job to actively consume, evaluate, and re-evaluate as much market data as we can every day to best manage portfolio risk. We know many individuals are too busy with their jobs to actively manage their portfolios or read this article in its entirety, so we have included a summary (see SUMMARY) for readers with limited time as well as an in-depth dive into our thoughts following Q1 (see FULL ARTICLE).

Summary

“Don’t Fight the Fed”- Investors are forgetting that it works on the way down as well as the way up. The Fed expanded their balance sheet by $4.8 trillion since the start of the pandemic while the US government added ~$5.5 trillion in stimulus. Combined stimulus of roughly half of US GDP of $20.5 trillion is the major driver of why the prices of stocks (along with homes, cars, boats, crypto, art, NFTs, etc) all went up over the past two years during a global pandemic. Now, the Fed dot plot shows 10 rate hikes in less than two years and they will be cutting trillions off the balance sheet probably starting on May 4th along with a 50 bps rate hike.
 
Stagflation is our base case for 2023. We continue to believe that the S&P will see a correction of at least 20% over the next one to two years as the Fed is more aggressive than expected to deal with inflation running higher than expected and easy money begins to decrease. Since World War II,
1. Every time Inflation (CPI) is over 5% a recession has occurred
2. Every time oil prices have doubled relative to the prior 2-year average ($54 in this case) a recession has occurred
3.  10 of the 13 prior recessions have been preceded by a tightening cycle by the Fed
4. 10 of the last 13 recessions have been preceded by the 10-year yield going below the 2-year yield
 
Any one of the above has a great track record in predicting a recession but all of them have now occurred. During this decline, we expect there to be several bear market rallies as people continue to call the bottom too early while fundamentals continue to worsen. We are expecting multiple negative preannouncements in early April and lowered guidance when companies report as well as more than one 50 bps hike by the Fed this year starting on May 4th. Additionally, Russia’s invasion of Ukraine is likely to lead to 1) higher mid to long-term inflation given disruption to both energy and agricultural supply; and 2) increased risk of a US recession in 2023.
 
We like companies that 1) benefit from economic reopening (not pandemic beneficiaries); 2) are profitable with good cash flow; 3) have growth but at a reasonable price; 4) benefit from higher-than-average inflation; 5) benefit from multi-year secular tailwinds. We foresee tailwinds in:
1) datacenter, office enterprise, and 5G infrastructure.
2) reopening plays such as airlines, cruise lines, travel, rideshare, and dating services as people adjust to covid becoming endemic.
3) banks which should benefit from higher interest rates.
4) alternative energy as geopolitics and fallout from the Russia-Ukraine War drives investment in the space.
 
We foresee headwinds for pandemic beneficiaries particularly in the PC and smartphone spaces while we see benefits for the services sector as economies continue to re-open and we learn to live with the pandemic. We would also note that inventory has built rapidly on company balance sheets as customers have been buying what they can get while waiting for what they cannot get. Unfortunately, as demand switches from the purchase of goods (only thing you could do during the pandemic) to services (what you want to do after being stuck indoors for ~2 years), you are likely to see demand disappoint. This is likely to cause an inventory correction as companies are finally able to get that last part they were waiting for.
 
To manage risk in this market, we are trading around our long-term positions as well as evaluating data daily. When we get moves that are statistically out of the ordinary, we trim our long positions on surges and likewise reduce our shorts on drops. Additionally, we try to recognize whether the facts have changed. In that case, we try to admit our mistake and remove the position at a loss and move forward to avoid greater losses later. To quote John Maynard Keynes, “When the facts change, I change my mind. What do you do, Sir?”
 
For retail investors that do not have the time to trade the market DAILY, we recommend cash until inflation, Fed tightening, and economic slowing run their course over the next one to two years. As a hedge fund, we trade around our long-term positions & evaluate data daily. Stock prices and information change daily and so do we. We try to invest when the risk adjusted possible returns are in our favor. For example, we may believe that the S&P will drop at least 20% this year, but we will have more longs than shorts when our 17 technical metrics indicate the market is oversold. We recognize not everyone has the time to do this which is why cash was one of our top 5 picks entering the year. Most of the time, cash is a terrible investment especially in a high inflationary environment, but if you are unable to actively manage your positions, it is better to lose 6-7% to inflation this year than 20%+ in a stock market drop. With the Fed being this far behind the curve on inflation, we will find out how much froth is in valuations as the Fed starts tightening as growth continues to slow.
 
For retail investors who would rather not sit in cash, we recommend these investors hedge their longs by shorting broad ETFs or megacap names as well as actively managing their portfolios. This will mitigate the dangerous potential for “unlimited” losses in single stock short positions, like “meme” stocks.
 
May your portfolio and your health be safe in these uncertain times,
Dan

FUll Article

We continue to believe that the S&P will see a correction of at least 20% over the next one to two years as the Fed is more aggressive than expected to deal with inflation that remains higher than expected.
 
Recession Indicators
Since World War II,
1.    Every time Inflation (CPI) is over 5% a recession has occurred
2.    Every time oil prices have doubled relative to the prior 2 year average ($54 in this case) a recession has occurred
3.    10 of the 13 prior recessions have been preceded by a tightening cycle by the Fed
4.    10 of the last 13 recessions have been preceded by the 10-year yield going below the 2-year yield
 
Any one of the above has a great track record in predicting a recession but all of them have now occurred. Stagflation is now our base case for 2023 with at least a 20% drop in the S&P from peak to trough over the next year. We would expect more than one 50 bps hike by the Fed this year starting on May 4th.
 
Bear Market Rallies
We would note that roughly ~25% of bear market rallies get back more than all of the losses of the prior leg lower before going to new lows. On average the rallies get back about 70% of the prior drop. We saw 4 double digit rallies as the S&P went down 49% on a price basis during the tech bubble and 5 double digit rallies during the Global Financial Crisis as the S&P went down 57%. In fact, 5 out of these 9 rallies were between 18-21% and each time people were quick to call the bottom even though the economic fundamentals were still getting worse. This time the S&P declined 9% from 2/2/22 through 3/8/22 and gained 11% from there to 3/29. This recent rally is not out of the ordinary.
 
Economic Fundamentals
But fundamentals are still getting worse and we expect multiple negative pre-announcements in early April and lowered guidance when companies formally report. We have already seen several high profile companies that had February quarter ends talk about the Russia invasion that started on February 24th affecting their business in Europe. Adobe (-36% from 52-week high), Restoration Hardware (-55%) and UIPath (-76%) come to mind. All of these stocks were hit hard (between 9-26%) on earnings results despite being well off their 52-week highs already. For companies whose quarters ended in March, they will have a full month of extra impact.
 
Russia’s invasion of Ukraine is likely to lead to 1) higher mid to long-term inflation given disruption to both energy and agricultural supply and 2) increased risk of a US recession in 2023. Stagflation is becoming our base case for 2023. There are 3M more job openings than people unemployed and unemployment is already at 3.6% versus a 70 year average of 5.8%. The leisure and hospitality industries still have ~1.5M less jobs than prior to the pandemic. As we all learn to live with Covid and start travelling, vacationing, going to indoor entertainment, etcetera, these jobs coming back will add even more to wage increases. Corporate costs on average are roughly 2/3rds driven by wages and 20% driven by supply chain and energy costs. Lower supply chain & commodity costs by year-end will not go down enough to offset rising wages keeping inflation higher than anticipated.
 
The growth of pandemic beneficiaries continues to slow and we still do not know where they will bottom, particularly if we enter a recession in 2023. This is leading to massive stock selloffs of pandemic beneficiaries exposed to e-commerce, digital payments, video conferencing, video streaming, digital learning, online exercising etc. As an example, in Q1 of 1999 Amazon had revenue growth of 236% y/y. That revenue growth went to 0% by Q3 of 2001 despite e-commerce being in its infancy as the US economy entered a recession. Amazon’s stock went from a peak of $106 to a bottom of $6 during this slowdown.
 
The most recent pandemic beneficiaries that are seeing a slowdown seem to be in the PC and smartphone space. Smartphone units shrank in 2020 (-10%) for the 4th yr in a row as replacement cycles lengthened but grew 6% in 2021. We are concerned about 2022. For PCs, demand was flat to down for 5 out of 7 years prior to Covid but saw double digit growth for the past 2 years due to purchases that enabled consumers to work from home and learn from home during Covid. The PC market is ~60% consumer and ~40% business and the consumer piece is now slowing down. Our shorts are concentrated in this sector currently and in retailers that sell stuff and not services.
 
The economy has also gone from “sell me stuff” to “sell me services”. US consumers have accumulated over $2 trillion in excess saving during the pandemic between the Fed and government free money. We bought “stuff” during the pandemic eg. Peloton bikes, smartphones, PCs, and furniture. Consumers now want “services” to start travelling, go on vacation, go to restaurants, go to sporting events, etcetera as the pandemic risk becomes a normal cost of living life.
 
 
The Federal Reserve
The #1 concern for investors in 2022 should continue to be that the Fed is so far behind the curve on dealing with inflation that they will have to be much more aggressive than in prior tightening cycles despite high inflation & geopolitical risk. Stagflation in 2023 is becoming our base case in which case market multiples should go to below average. According to the Taylor rule which used to be a guidepost for central bank policy prior to the Global Financial Crisis, the Fed funds rate should already be above 9% versus the current level of 0.25-0.5%.
 
Valuations
Unfortunately, most valuation metrics are near record highs such as the market cap of the entire US stock market divided by US GDP is at 1.9x versus a peak during the tech bubble of 1.4x and an average of 0.8x. We would also note that market multiples are typically below average in periods where inflation was over 3%. Despite 50% earnings growth from 1972 to 1974, the stock market declined by ~50%. Slowing growth and high inflation crushed market multiples with the trailing PE ratio of the S&P500 going from 20x to 7x. The trailing PE multiple today is 23x.

Investments

This is the Jerry Maguire stock market. It has gone from a “sell me the dream” to “show me the money” as:
1) the Fed becomes aggressive to deal with inflation and 2) growth rates slow due to high inflation & the removal of easy money. Today, companies need to be able to show profitable growth at a reasonable multiple versus before when rosy forecasts of huge markets a decade from now were sufficient despite huge current losses.
 
Ideally our portfolio companies would have all of the following characteristics:
1)            Benefit from economic reopening (not pandemic beneficiaries)
2)            Profitable with good cash flow
3)            Growth but at a reasonable price
4)            Benefit from higher than average inflation
5)            Benefit from multi-year secular tailwinds
 
Most stocks will not be able to withstand a 20%+ decline in the S&P
As such we are counting on: 1) our shorts to deliver positive the returns for the year, 2) outperformance of our longs versus an expected market decline of at least 20%, and 3) aggressive rebalancing of shorts triggered by the 17 technical indicators we use to avoid bear market rallies. We raise a high degree of cash on market rallies by covering shorts and then re-short on bounces.
 
Three simultaneous investment cycles: 1) datacenter for the large internet companies, 2) enterprise as workers come back to the office, & 3) 5G infrastructure as this becomes the dominant technology for smartphones.
-We own a basket of names such as Cisco ($CSCO), Ciena ($CIEN), Nokia ($NOK) and Ericsson ($ERIC) that should all benefit from these trends. There are other communication infrastructure stocks that would fit as well and we are constantly adding and subtracting names from this list based on or perception of risk to reward. For example, we bought Nokia and Ericsson during the latest market drop in March given their proximity to Russia hurt them more than other names in the infrastructure space. We also believe the risks to Ericsson from their latest disclosures around illegal payments are overblown given this issue was somewhat addressed in their fines in 2019. These names though are hurt by higher inflation affecting their costs.
 
Loan growth picking up & treasury yields going higher
-$KRE: We believe 10 year treasury yields will reach ~3% in 2022 and loan growth will pick up as easy money from fiscal & monetary policies get dialed back. As easy monetary and fiscal policies get dialed back in 2022, corporations and individuals will increasingly have to turn to the banking system for their financing needs going forward. In addition, as rates head higher in 2022, this will allow banks to lend at higher levels and increase their profitability. Regional banks also avoid the geopolitical risks involved with the larger international banks. The big concern for the future is default rates going up when we enter the next recession which we believe is in 2023. Also a flattening yield curve is not as good for the net interest income of banks as when it is steeper. These are factors to watch. Banks though do not have multi-year secular tailwinds though and argument could be made for rising interest rates after a ~40 year downtrend since the 1980s. They are also hurt by new financial innovations like buy now pay later (BNPL) unless they are investing as well.
 
The world learning to live with Covid & re-opening by year-end
-During the recent decline, we started buying a basket of re-opening beneficiaries including in airlines ($LUV), cruise lines ($NCLH), hotels ($H), travel ($ABNB), ride-share ($UBER), with many crushed even more due to Europe exposure or rising oil prices. There are many other names that would fit as well and we are constantly adding and subtracting names from this list based on or perception of risk to reward. We believe by year-end, we will all accept catching Covid to varying degrees as acceptable risk to living life. China is a wildcard in this regard as they continue to pursue a zero-Covid policy but by year-end we believe they will also go down this path. We also believe Russia’s invasion of the Ukraine will be resolved in Q2.
 
Geopolitics driving a resurgence in alternative energy investment
-We own a basket of stocks in this sector. $ICLN which is down ~35% from its highs in early 2021 is a good way to get diversified exposure to the space. Europe’s dependence on Russia for energy in particular should drive a multi-year investment cycle in the sector. We also have exposure in the Uranium sector as nuclear gets reconsidered.
 
On March 2nd, we tweeted from @DanielTNiles that we removed $USO from our 2022 Top5 Picks following a gain of 39% year-to-date which tracks WTI Oil prices which were at $111 up 86% year-over-year!
-There is an adage that “the cure for high oil prices is high oil prices.” It slows economic growth, increases recession risk & reduces oil demand. We are looking to get long oil again in the $90s. Oil demand in 2022 should still surpass the record levels seen prior to the pandemic while OPEC+ spare capacity is low and supply remains restricted by environmental concerns. Russia’s invasion of Ukraine cuts available capacity even more over the longer-term. When there is eventually some sort of peace agreement (we expect this in Q2), all commodity prices will most likely get hit hard and that is when we plan to get long in a big way again.
 
SEVERAL TIMES, we have been short the $USO (which tracks the West Texas Intermediate oil prices) as a trade, since Russia invaded the Ukraine. Commodity prices are not like stocks. Commodity prices cannot go up infinitely (especially oil) given higher prices kill demand which drives the price back down. This is unlike stocks that can keep going higher as the economy expands and they take market share. Despite our long-term bullishness on oil prices, when prices moved quickly to levels that we perceived were too high following Russia’s invasion of the Ukraine, we sold our long. We then put on short positions but covered on big drops. This is despite our long-term goal to own the $USO or related energy names on a resolution of Russia/Ukraine that should send most commodity prices initially lower.

Managing The Risk in Your Portfolio

As a hedge fund, we trade around our long-term positions & evaluate data daily. Stock prices and information change daily and so do we. We try to invest when the risk adjusted possible returns are in our favor. For example, we may believe that the S&P will drop at least 20% this year, but we will have more longs than shorts when our 17 technical metrics indicate the market is oversold.

When we get moves that are statistically out of the ordinary, we trim our long positions on surges and likewise reduce our shorts on drops. We will also replace names with others in the same sector if we believe there is a better risk adjusted return in those names. We trade multiple stocks every single day. Sometimes it is making a current position bigger or smaller. In shorts this is particularly important. Stocks in general do not go to zero so when you get a multi- standard deviation move lower, you should cover.

You should view commentary on a sector as a way to think about the space and not focus as much on the individual names. A rising tide lifts all boats. Sometimes the best boats are only obvious after the fact so broader exposure to an investment theme is better, especially in the early stages. That is why we try to give a thought process around investments and tend to recommend ETFs that track a sector for more retail-oriented investors given the company specific risk in owning any individual stock.

Adjust your positions as fundamentals change or play out. You should evaluate each position every day. Your cash is valuable. You should be only willing to risk it in your best ideas. With double digit percentage moves that are happening daily, especially as we enter the Q1 earnings season, your best ideas might be changing daily. Sometimes, your best longs (mostly in the commodity sector) also become your best shorts after a surge higher. But you must trade and watch it daily. If not, stay out!

“When the facts change, I change my mind. What do you do, Sir?” - John Maynard Keynes. This is particularly important when you have lost money in an investment. We always have things we get wrong every year. What we try to recognize is whether the facts have changed. In that case, we try to admit our mistake and remove the position at a loss and move forward. $FB (heightened competition from TikTok) and $KWEB (Chinese government continuing to increase regulation on internet companies) are two of our biggest mistakes this year where we took the beating and sold at a loss when we realized that their fundamental backdrop had changed. This avoided a much bigger loss later on.

For retail investors that do not have the time to trade the market DAILY, we recommend cash until inflation, Fed tightening and economic slowing run their course over the next one to two years. Cash was one of our top 5 picks entering the year. Most of the time, this is a terrible investment especially in a high inflationary environment, but it is better to lose 6-7% to inflation this year than 20%+ in a stock market drop. With the Fed being this far behind the curve on inflation, we will find out how much froth is in valuations as the Fed starts tightening as growth continues to slow. For retail investors who would rather hedge their longs rather than sit in cash, we recommend shorting broad ETFs or megacap names. This will mitigate the dangerous potential for “unlimited” losses in single stock short positions, like “meme” stocks.

​May your portfolio and your health be safe in these uncertain times,
Dan