Our compliance department has approved disclosing the following. Our Satori Funds are private offerings. Our limited partners were up on both a gross and net basis in 2022 with the S&P down 19% and Nasdaq down 33% and were up year-to-date (5/19/23) on both a gross and net basis in 2023 as well. (For more information and actual returns for 2023 and years prior, please click on the “Learn More” button on our home page.)
On 4/12/23 we wrote “We have a bias towards a short-term rally. However, longer-term we see earnings cuts & Fed balance sheet shrinkage driving the market to new lows in the second half of 2023.”
We have certainly had the rally we expected and then some.
But the market has been much more resilient at these high levels than we expected despite:
The market has been supported in 2023 by:
We are focused on valuation given that determines the risk you are taking versus the potential reward. We made money in 2022 due to this same focus. EPS estimates for the S&P500 for 2023 peaked at $252 in June of last year and have now come down to $220. We believe they will bottom at about $200 which is the normal 20% decline seen during recessions.
Retail results this past week from Target, Walmart and Home Depot showed the consumer was under pressure as spending was shifting to consumer staples like groceries and away from discretionary and big ticket items. Pressure on the consumer was blamed on a combination of inflation sapping consumer buying power, poor weather and lower tax refunds. We also believe that rising credit card balances and falling excess savings from the pandemic peak will put the consumers under increasing pressure through the rest of the year.
We are negative on enterprise demand as the US economy slows down and credit gets tighter following the recent bank failures. We would note that orders continue to weaken. Last week Cisco reported that product orders fell by 23% y/y in their April quarter despite an 8% easier compare as product lead times were reduced 40% Q/Q. On a positive note, Cisco’s stock did close up 5% last week during a strong week for the market and technology stocks.
We believe the S&P being up in March & April despite three of the four largest bank failures in the US is due to the Fed balance sheet expansion by almost $400B in 3 weeks which reversed 5 months of balance sheet shrinkage. In 2020 during the onset of a global pandemic the S&P was up 16% (double the yearly average) due to the Fed balance sheet expanding by $3.2 trillion to $7.4 trillion. Or you believe a global pandemic is terrific.
The Fed balance sheet is now down $277B over the past 8 weeks as the Fed continues their fight against inflation but the balance sheet is still up 1% versus the lows prior to the SVB failure.
In general, we think this could play out like during the GFC. There was a 24% surge in the S&P over 6 weeks following the passage of TARP in October of 2008 after the failure of Lehman Brothers and then Washington Mutual. During the rally, the Fed Balance sheet expanded from $900B to $2.2T in less than 4 months by year-end 2008. The S&P then dropped 28% in 2 months starting in January 6th of 2009 to its ultimate lows in March of 2009. The Fed balance sheet dropped by $300B to $1.9T by early March of 2009 as corporate earnings estimates had to get adjusted lower during Q1 due to the fallout of the Global Financial Crisis.
Our outlook for the rest of the year is based on the expectations of a recession combined with no rate cuts by the Fed due to inflation falling but staying above 3% and the Fed’s 2% target. First there are more than 50% more jobs than people unemployed keeping wages high in the US and second the re-opening of China after a 3 year lockdown should keep commodity prices firm. We believe the Fed is done raising rates. But unlike the market expectations of 2-3 rate cuts later this year, we think the Fed will remain on hold. We do not see core PCE dropping below 3% this year versus the Fed target of 2%.
As a result, we are biased towards a decline in the S&P through the rest of the year driven by a recession in late 2023 driving lower earnings. Valuations as we saw with many stocks in 2021 do not matter until they do. We have been surprised by the expansion in multiples for seven of the largest technology companies this year driven in general by a common theme of Generative AI. Without these names, the S&P composed of 493 other stocks would be down for the year. On a risk to reward basis, we believe the worst case downside risk is to 3000 on the S&P ($200 in 2023 EPS vs $220 today at a 15x PE vs 19x today) versus minimal upside from current levels.
Stock Specific Thoughts
Q1 earnings from the mega cap technology companies was generally better than expected with EPS forecasts going higher for all the big tech giants (Google, Meta, Amazon and Microsoft) with the exception of Apple.
We bought Amazon after the decline following earnings results and are the most positive we have been on that name in over a year given estimates are finally going higher after a year of cuts. We believe the strength in their retail business is more important over the long-term than the slowing in Amazon Web Services growth. Amazon is now one of our largest positions. It is hedged with shorts in cloud computing software stocks that have rallied hard over earnings season.
We still like Meta especially given its valuation which is near a market multiple while Reels picks up share versus TikTok and their AI powered ad tool Advantage+ helps with monetization after the Apple privacy induced issues. META was a Top 5 Pick for us entering this year.
While we are encouraged by Google’s results and are not worried about much share loss versus Bing, we worry that the weakness we have seen in traditional advertising demand at names like Disney and Paramount will start showing up in online ad demand later this year. We believe Meta is better positioned to withstand an ad spending slow down. As a result, our Meta long position is now hedged with a small short position in Google. We initially bought Google after their slight stock decline on a solid quarter but with the recent rise in the stock, we have sold the position and shorted a small amount relative to our META long.
For Apple, March quarter results were better than expected but June quarter estimates were cut by 2-3% on both revs and EPS but surprisingly the stock was up 5% the day after earnings. We believe this has more to due with relief following results from TSM and Qualcomm and their comments on smartphone demand. The stickiness of the Apple ecosystem and view that their products are consumer staples has not been borne out with actual results. Services revenues were less than expected with just 5.5% y/y growth and was guided to roughly the same levels for June. At a 29x PE relative to the S&P at 19x, the risk to reward is not in your favor in owning Apple. As a reminder, smartphone units peaked in 2016 and were down for 4 years in a row prior to Covid supercharging upgrades & demand for work from home & learn from home. Apple revs were down 2% in FY19 prior to Covid accelerating that to a peak of 54% y/y in March of 2021 and now -3% y/y in March of 2023 with forecasts of -3% y/y in June as well and EPS down 1% y/y.
Microsoft had solid results with estimates also increasing going forward. However we worry about the optimism over ChatGPT that is reflected in its valuation of 31x versus the S&P at 19x especially given Google is only at 21x. On a positive note, we do believe the overall PC market bottomed in Q1 with a decline of roughly 30% y/y for the industry in Q1.
Intel should benefit from GMs bottoming, PC demand improving & Generative AI demand. We believe that gross margins bottomed out in the March quarter and have the potential for recovering faster than expected as the ramp in new process technologies reverse the startup costs that depressed margins in the March quarter. We believe Intel will also benefit from the rise in AI needing more powerful microprocessors that have many more cores. From a long-term perspective, we believe share losses versus AMD over the past 5 years are starting to slow as Intel benefits from going all in on EUV 2 years ago. While Intel is likely to lose server share through 2023, we believe this will stabilize in 2024 with introduction of new chips. Relative valuation for Intel is compelling within semis. Intel trades at a lower price to book value (1.2x) than Micron (1.5x) a commodity memory manufacturer with negative gross margins. We think the PC market at down ~30% y/y in Q1 for the industry will recover over the course of the next year.
In general, we believe semiconductor stocks related to PCs and smartphones are closer to a fundamental bottom given they have been going through an inventory correction for about one year now.
With China re-opening, we favor commodity linked names that were hit on fears of a global recession.
We like oil related stocks ($XOP $OIH) given the Strategic Petroleum Reserve is down to the lowest level since 1983 and demand should pick up in 2023 with China exiting their zero Covid policies after 3 years. In general, we like commodities that in general have come down over growth fears.
$URA remains our longer-term play on energy security and green energy. Since the disaster at Fukushima in 2011, nuclear as a source of energy production was significantly curtailed over the next decade. However, with Russia invading Ukraine, the world is looking again to nuclear for clean energy and as a means of gaining further energy independence from Russia. We expect Uranium related names to perform well and the $URA ETF is a great way to get diversified exposure to the space.
We like $DKNG given the sports-betting companies are now focused on profitability vs spending exorbitant amounts of money to acquire customers at all costs in 2021/22. Sports betting is one of the last big markets to go online and the two market share leaders, DraftKings and FanDuel owned by $FLTR.LN, should both turn EBITDA positive later this year. The tighter credit markets should also put increasing pressure on many of the smaller money losing players in this sector and enable the two leaders to gain even more share profitability. Scale is an advantage. Obviously, a recession will put pressure in the other direction but we believe these two factors should offset one another. $DKNG trades at just 4x EV/Sales but sales are expected to grow ~40% this year.
$XLV - No one wants to die and many of us (including myself) have put off going to the doctor since Covid. The healthcare sector typically outperforms during recessions. In 2022, when the S&P dropped 18%, the $XLV (the S&P Healthcare Sector ETF) lost 2%. In 2008, when the S&P dropped 37%, the $XLV lost only 23%. The rotation out of $XLV -3% to start the year has created some interesting opportunities.
We are balancing our longs with shorts where valuations remain high and estimates need to come lower. We are especially biased against high growth software, hardware & consulting names that are based on the number of employees employed at technology companies or the consumption of cloud resources.
As layoffs continue at high tech companies in the “year of efficiency,” these growth rates are likely to get revised lower. In addition, financial services companies are the second largest IT spenders at 11-12% of the $4.4 trillion IT spending market and only second to the tech companies themselves. We believe that the increase in spending on generative AI is not enough to offset the decrease in spending in other parts of their business.
Cash in risk free 3-month T-bills yielding 5.3% vs just 0.03% to start 2022 is a great investment alternative. While the singular focus of my fund is to maximize reward while minimizing risk by trading the market daily, not everybody can trade daily. Having a big cash reserve allows flexibility to reinvest if the S&P goes lower in 2023. Cash allows us to wait for the fundamentals to bottom and make calculated investments that maximize reward while minimizing risk. You are essentially being paid for your patience to wait until the risk to reward is in your favor.
It will take time for the cumulative impact of Fed rate increases and tighter lending standards following the recent bank failures to show up in the real economy.
Portfolio Construction & Goals
The goal of a hedge fund should be to first protect your capital and minimize losses, while also positioning for potential gains during key market shifts. Our goal is to provide consistent high single digit returns over time with high Alpha generation while maintaining a low correlation to the S&P. This has been accomplished by protecting assets during periods of severe stock market declines like in 2022. Our average net exposure is a very conservative 25% over the past 19 years.
We are a low volatility and high risk adjusted return portfolio. If you are looking for a high volatility and high absolute return portfolio, the thoughts above may not be appropriate for you. None of our stock positions (either long or short) should be looked at in isolation as it is part of a portfolio.
All the best in your investing,
Dan & the Satori Team
Dan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund.