Q2 Market Update

Summary

The Fed is still Hiking (Don’t Fight the Fed) and Earnings Estimates are coming down for the first time in 2 years (Don’t Fight the Fundamentals.)
While we are not legally allowed to get too specific given we are a private investment vehicle and highly regulated, I can share that we made money in June with the S&P down 8% but also in July with the S&P up 9%. We are also currently up for the year. This has happened by managing risk through constant position resizing. In general, we cut positions sizes in front of earnings given the increased volatility and also when we get multi-standard deviation (big moves) in our favor from related events (eg Snapchat blowup or Walmart negative pre-announcement).

Details

The big S&P/Nasdaq rally of 9%/12% in July was due to

1. Expectations by investors that the Fed would be CUTTING rates in Q1 of 2023. The S&P rose 5% in the last 3 trading days of the week driven by a 3% gain on Wednesday, the day of the Fed decision.
2. Drop in commodity prices (WTI down 7%) helping the peak inflation narrative.
3. 36 bps drop in 10-year treasury yields helping tech valuations with 16 bps drop following the Fed decision.
4. Lowered expectations after the S&P/Nasdaq declined 8/9% in June with negative pre-announcements by Target, Microsoft, SnapChat, Intel (soft lower by CFO at conference).
5. Guidance (actual and implied) that was all lower for the September quarter by the megacap tech stocks but that could have been worse.

For the first time in over two years, earnings season revisions for the S&P500 for next twelve months EPS has fallen into negative territory. Don’t Fight the Fundamentals. We think EPS expectations for CY2023 will drop by ~20% over the course of this next year to $200 from ~$250. Fed tightening just started this year and will show up with a lag in future earnings over the next year.

Companies try to guide to a low bar for the next quarter when they report so they can beat it so we look at results compared to prior averages. Over the past 5 years, S&P500 companies on average have beaten rev/EPS for the reported quarter 69%/77% of the time. But this earnings season, the beats are below average at 60%/73%. Also the percent by which companies are exceeding published revenues for the quarter reported is the lowest since Q2 of 2020.

EPS expectations for ALL mega cap tech companies went down for the September quarter after June results were reported. This includes Apple, Microsoft, Facebook, Google and Amazon. Certainly, June quarter results were “better than feared” for some and both Apple & Amazon beat both rev & EPS published estimates for the June quarter but even for them, their stock reactions had a lot to do with prior companies lowering the bar such as Qualcomm (for Apple) and Walmart (for Amazon).

Apple ($AAPL)

Both Apple (up 3% on their print) & Qualcomm beat both rev/EPS for the June quarter but Apple followed the 5% estimate cut for the September quarter by Qualcomm the prior day (down 5% on their print.) The Qualcomm cut was due to worse than expected Android smartphone demand. We talked about this difference between the weakness in the low/mid-range Android market and the relative strength in the high-end Apple phones at the beginning of last week on CNBC as a reason for owning Apple in July which we sold before they reported. But Apple EPS estimates also came down for their September quarter by 3% but this followed the lowered bar by Qualcomm. Apple saw little evidence of weaker consumer demand but did state the macro was impacting both Wearables and Services (their highest margin business). Apple was a major pandemic beneficiary. Revenues were up 2% in 2019 but then surged to up 54% y/y in the March quarter of 2021. This has now decelerated to just 2% y/y revenue growth for their June quarter. A 27x CY22 PE for that type of growth at Apple is too expensive for us compared to the S&P at 18x for 13% revenue growth. We believe revenues will be declining y/y by the December quarter for Apple versus expectations for 3% y/y growth. This assumes 44% sequential growth for the holiday quarter. We made money during the month on our Apple long.

Amazon ($AMZN)

Amazon (up 10% on their print) beat both rev/EPS and followed the negative pre-announcement by Walmart (down 8%). While Amazon beat both revenue & EPS for the June quarter, it is not that surprising to us.

But EPS estimates for the September quarter for Amazon still go down. We sold the position (over 15% of assets in our fund) earlier in the week before earnings after a huge gain in case we were wrong. This was our top profit generator during the month. Out of all the megacap names, this is the report we found the most encouraging. We also believe there is the potential for Amazon to gain retail market share during a recession as consumers become more price conscious. We believe they are also growing into their expansion since Covid which will help improve future profitability. We plan to use market weakness to buy back some shares.

Google ($GOOGL)

Google (up 8% on their print) missed both rev/EPS consensus and forward rev/EPS went down on their report but this followed the horrific results by $SNAP (-39% on their print) which lowered expectations drastically for Google. This had been a 15% short position for us which we lowered to 2% into the Google print given the hit it took from the Snapchat debacle.

Our Google short was our third most profitable position for the month given our risk management.

We continue to believe that advertiser spending will decline over the next two years and this quarter started that process. Given Google’s size, we would expect more of an impact in the future and do not believe their revenues will be able to grow 25% over the next two years from CY21 to CY23. We note that total advertising spending declined by over 20% in the two years of 2008 & 2009. Online spending is now roughly 2/3rds of the total ad spend today versus closer to 12% back then. It will be very difficult for online advertising companies like Google to gain enough share today to avoid an overall ad spending downturn.
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We think the upcoming reports by the traditional media companies will help add more datapoints. We think the scatter market is quite weak in particular following a solid TV advertising upfront earlier in the year. We would not own any of them into the print. One positive for the ad market however will be the 2022 mid-term elections in Q4.

Meta ($META)

Unfortunately, Meta (down 5% on their print) missed both rev/EPS consensus as well but followed Google (up 8% on their print.) We sold Meta earlier in the month when we got concerned over an internet ad slowdown. However, we started buying Meta back slowly over the past couple of days following earnings. Expectations have been lowered for Meta for revs to increase only 1% this year and for EPS to fall 11%. While Google expectations have also come down, they are still higher at 14% rev growth while EPS declines by 2%. Meta though is now down to a 13x PE for CY22 while Google is at 20x versus the S&P at 18x. While Meta is struggling like every other internet ad driven pandemic beneficiary, we do not believe social media is going away anytime soon. To be clear, we believe estimates for 2023 still need to be cut for both Meta and Google as economic growth slows further from here but we think a long Meta and short Google position makes sense

Microsoft ($MSFT)

As for Microsoft (up 7% on their print), they missed both revs/EPS consensus for their June quarter, but they had already negatively pre-announcing earlier. This was a 7% short position for us at one point which we lowered to 2% into their print. Despite, the earlier negative pre-announcement, FY23 (Jun) EPS dropped by about $0.32 to $10.30. It would have dropped an additional $0.40 if Microsoft hadn’t changed the depreciation life on their cloud infrastructure from 4-6 years. With 93% of the Wall Street analysts having a buy rating on the stock, it is not a surprise that this was not highlighted. We lost ~5 basis points for the month of July on our Microsoft short but being short Microsoft has been a great profit generator for the year. We plan to increase our Microsoft short position in the future. When accounting changes are used to cushion a blow to earnings, we always get concerned. At a 30x PE with their PC end market slowing, we believe risks are not properly discounted.

Intel ($INTC)

Speaking of the PC market, we sold Intel before the print given our vocal concerns over the PC market being a pandemic beneficiary. We had owned Intel along with TSMC ($TSM our 4th largest profit generator during the month) and Global Foundries ($GFS) for any undue optimism from the passing of the ChipsAct during the month. However, we bought some Intel back after their horrific results (the worst we can remember for them with a 15% revenue miss and 17% miss for Q3.) Intel forecasts for the first time in over a year may be reasonable with revs forecast down 14% and a 15x PE. We think only half their problems are related to market share losses and we are still short a lot of other semiconductor and software related companies where we think earnings risk is high. We just need Intel to outperform our related semiconductor shorts much like with many of our long positions. It also pairs well against our Microsoft short. Having said that, we have a small position currently and need to do more work to get comfortable with the risks which remain. The continued pushout of their new server architecture being the most troubling which should allow AMD to gain share through 2023 in that segment. The ChipsAct will also only result in $1-2B going to Intel in 2023 so it really does not move the needle. One of the most positive developments during the quarter was Intel adding MediaTek as a foundry customer. We also think there is a better than even chance that Intel adds Apple at some point as a foundry customer. Apple relies heavily on TSMC currently for their chips and the geopolitics around Taiwan being “reunified” by China at some point could cause a major issue for them. We currently own Global Foundries but have exited our TSMC position given the nice run in the name and our concerns over a multi quarter semiconductor inventory correction. We are likely to cut our $GFS position into their upcoming results given the 28% increase in the stock in July.

China Internet ($KWEB)

We are the most torn on this sector. We recommended adding this position back on May 12th and since then, it is up 14% while the S&P is up 5%.

We trimmed some of our position following the massive outperformance in June with KWEB up 12% versus the 8% decline in the S&P. Again, this was due to risk management following an outsized gain. We try to do this with all of our positions. However, KWEB declined 13% in July versus the 9% gain in the S&P. We sold our entire KWEB position prior to this most recent week given our concerns over upcoming big cap tech earnings. But while the S&P rose 4% on Fed optimism and “better than feared” results this prior week, KWEB dropped 5%. This negative divergence was driven by

1. The mortgage payment revolt in the incredibly important housing sector.
2. Some small Covid related lockdowns.
3. Renewed delisting fears.
4. Regulatory pressure with Jack Ma reportedly divesting his Ant Financial stake.

​We continue to believe that the government in China will try to pull out all the stops to stimulate their economy before the National People's Congress in November much like in the US before mid-terms. However, the property market & related industries accounts for roughly 25-30% of China GDP and we remember well what happened in the US in 2008/09.
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We have no position currently and are evaluating the incoming data.

Risk management

Risk management has been the key to making money in this volatile market for us. In general, we cut positions sizes in front of earnings given the increased volatility and also when we get multi-standard deviation (big moves) in our favor from related events (e.g. Snapchat blowup taking down Google.)

Along with risk management, our batting average (getting more positions right than wrong) & alpha generation (longs outperforming shorts) is what matters to generating profits over the long run in the overall portfolio.

We have certainly had our share of big individual losses earlier during the year, but it is a portfolio of positions. Any one position can go drastically wrong, and many have. Meta was a disaster for us when they reported the March quarter following the Apple privacy changes (we sold it at ~$250 in the after-mkt.) Our re-opening basket (airlines, cruiselines, hotels, ride-sharing) got clobbered in general on recession fears (all of them), high debt levels (cruiselines) capacity concerns (lack of pilots for airlines) or lack of profitability (ride-sharing) despite a generally strong outlook on demand. We are not recommending any names in these sectors right now and have taken our beating and moved on.  Thankfully our shorts on the pandemic beneficiaries helped balance this out.

The key to managing losing positions, is admitting when you are wrong and cutting the position to minimize the losses though some have been painful. One important nuance is a long position that is down can still be a great position if it is outperforming the short position that is matched up against it. Also the relative sizing of the two is important. We have definitely lost money on our long positions this year. But our shorts have made us more money leading to overall profitability in the fund for the year.

OUTLOOK

Companies whose quarters end in July could have a much bigger problem than those whose quarters ended in June. We would note that business seemed okay in April but really seemed to take a turn for the worst in the month of May going forward. Snapchat revs for example were up 30% year-over-year in April and collapsed to flat by July.

We also believe that the cloud services companies have increased risk going forward given they are consumptions models that follow a slowdown at their customers. We have already seen this from some of the more pureplay cloud vendors such as Snowflake and ServiceNow. We believe Microsoft Azure, Amazon Web Services and Google Cloud Platform also need to be monitored. Their combined cloud platform revenues are now growing at an incredible estimated run rate of $147B up 36% y/y versus 41% in Q1. Everyone went onto the internet during Covid taking up consumption on these platforms. As consumers go back to a more normal lifestyle and business slows down at the online pandemic beneficiaries, eventually that will affect growth rates at the big cloud providers. Growth rates are already slowing but there is risk that they may slow much more than expected in the future.
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Microsoft, Amazon, and Google (latter two covered by Ross Sandler) reported results over the last week that showed another quarter of solid performance in aggregate (Microsoft Corp.: Not All Is Perfect, But Good Enough, 7/26/22). The three vendors are now at a collective annualized run-rate of $147bn, growing ~36% on a y/y basis (vs. 41% in Q1).

As for the Fed, we think investors were too euphoric and misinterpreted Jerome Powell’s statement of rates being at neutral at 2.5% while ignoring his statement of looking at the Summary of Economic Projections (SEP) for the best judge of where rates should be in the future. There will be a lot of Fed governors speaking over the next week. We believe this may refocus investors on the Fed commitment to raising rates in the face of an economic slowdown to get inflation permanently under control. Jerome Powell does not want to go down in history as the new Arthur Burns, the head of the Fed in the early 1970s that let inflation become entrenched.

The Eurodollars futures market is currently pricing in 75 basis points in Fed rate CUTS now in 2023 starting in Q1. It will be a major problem for the stock market if the Fed pushes back in upcoming speeches to still expect rate hikes in 2023.

Powell has alluded to the Fed making the same mistake twice in the 1970s by cutting rates too earlier and allowing inflation to become entrenched. He also has said that he admires Paul Volcker. There over 11.3M job openings for every 5.3M people unemployed. US GDP is 3/4ths services based. Wage inflation will be here for a lot longer than investors want. Also home prices are up over 20% y/y with over a year lag before it fully impacts rents (30-40% of inflation measures) historically. Finally, we believe China will stimulate their economy going into their National People's Congress in November which should lead to a rally in commodity prices which have come down recently.

We believe the Fed will be raising rates in early 2023 while earnings estimates continue to head lower as the Fed tries to kill inflation.

1. In the 1970s, it took 18-21 months for the S&P to finally reach its bottom of down 27-48%.
2. During the Global Financial Crisis and Tech Bubble, it took 17-31 months to find the bottom while the S&P declined 49-57%.
3. We are only 7 months into this downturn and the Fed still has a long way to go with rates at 2.5% and still needing to get to 3.25-3.50% by year-end.

We believe this is yet another bear market rally

1. There were 5 rallies in the S&P of 18-21% during the GFC (2x) and bursting of the tech bubble (3x) while the S&P ultimately dropped 49-57%.
2. During the 3 inflation driven bear markets around the 1970s, the S&P had 16 rallies that averaged 8% each while the S&P declined between 27 to 48%.
3. In 2022, the S&P has had 4 rallies averaging 9% each while losing 13% YTD.

However, some believe the lows are in much like on 8/12/1982, three years after Paul Volcker took office. But there are some key differences in both price stability and unemployment versus today.

1. By August of 1982, Volcker had already been cutting rates for over a year starting in June of 1981 from 20% back to 11%. Today the Fed is still raising rates and they are at 2.5% going to 3.25-3.5% by year end and 4% in 2023 if you believe their Summary of Economic Projections.
2. By August of 1982, inflation (CPI) had already fallen for over two years from a peak of 14.8% in March of 1980 to 6.4%. Today CPI is at 9.1% and has been going up.
3. In August of 1982, unemployment had risen from 7.5% to 9.8% when the rate cuts started in June of 1981. Today unemployment is within 0.1% of a 50 year low at 3.6%.
4. By Q3 of 1982, we already had 6 negative GDP prints in over 2 years going back to Q2 of 1980. We have just had 2 negative GDP prints.
5. In August of 1982, the S&P trailing PE was 7x. Today it is at 20x.

​During high inflation environments, the trailing PE for the S&P is much lower than average. For nearly the last 70 years, whenever CPI has been above 3% the trailing PE has averaged 15x versus 20x today. Whenever CPI has been above 5%, the trailing PE has averaged 12x. We use trailing PE because forward estimates always come down when entering a recession.

We continue to believe that the S&P has not seen the lows yet and that this is yet another bear market rally. If the Fed does lower rates at the beginning of 2023 which we believe would be a mistake and will not happen, we may have seen the bottom till the next fight against inflation in late 2023.

Portfolio Positioning

We once again have more shorts than longs with over 25% of the portfolio in cash given the market by many metrics seems like it is overbought.

For the retail investor that is not able to manage their portfolio full-time, we would recommend cash despite losing ~5-7% to inflation rather than losing 30-50% to a potential stock market decline. As in prior stock market bottoms, we believe the Fed will have to be near the end of their rate hikes to have a realistic chance at “the bottom” versus a short-term tradable bottom.

Best of luck in these challenging times,
Dan