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MID Q2 Market Update

5/22/2022

17 Comments

 
The S&P just had its 7th consecutive week of losses, which is only the fourth time in history including 1970 (8 weeks), 1980 (7 weeks) and 2001 (8 weeks). 

We thought last week would be up especially when the S&P climbed 2% on 5/17 (advancing 4% from its close on 5/12) despite scary results from Walmart which drove a 11% drop in its stock (its worst daily decline since Black Monday of 1987.) 

But then came Target, which echoed Walmart’s negative comments on the consumer, compressing margins and surging unsold inventory. Their stock dropped 25% (their worst daily decline as well since Black Monday of 1987) and drove the S&P down 4% on 5/18.

Results from Home Depot and Lowe’s did not alleviate investor concerns about a slowdown in the housing market which generally precedes recessions. Both names are now down ~30% from their record highs in December of last year and declined 3-5% during the week.

And finally, disappointing results by technology stalwarts Cisco (down 13% for the week) and Applied Materials (down 5% for the week) sent those stocks even lower despite only a 13-14x PE ratio versus 17x for the S&P. Both are now down over 30% from their all-time highs. This punished related large cap technology names (QQQ down 4% for the week) which are now down 29% from their all-time highs.

Furthermore, a collapse in a so called “stable-coin” in crypto did not help more speculative technology names. TerraUSD (UST), an algorithmic (not asset backed) crypto that was supposed to be pegged to 1 US dollar, is now trading near zero ($1.00 to $0.05). The collapse of UST and LUNA led a crypto market sell off which wiped out $400 billion in value at one point.

As a result, the S&P/Nasdaq on Friday 5/20 closed -0.7%/-0.1% below their prior 52-week lows on 5/12. However, China technology names were quite strong with $KWEB (China internet ETF) up 8% from 5/12. Unlike most other stock markets, many of China’s stock market woes are self-inflicted driven by: 1) their drive to common prosperity, 2) heavy regulation of technology companies, and 3) zero-Covid policies locking down major cities. But there are signs that the regulatory pressure is nearing its end along with some more flexible Covid policies. $KWEB is down 74% from its all-time record highs versus the Nasdaq which is down 30%. We have a large long position in $KWEB which we hedged with short positions in big cap US technology names last week before earnings results. The QQQ (Nasdaq 100) fell 5.7% from its highs on 5/17 to its close on 5/20. We have since covered those shorts.

The market is near oversold levels and we have technical metrics that will hopefully help us take advantage of the usual bear market rallies on the way lower:
  • There were 5 rallies in the S&P of 18-21% during the Global Financial Crisis and bursting of the tech bubble while the S&P ultimately dropped 49-57%.
  • Bear market rallies typically get back 70% of the losses of the prior move lower with over a quarter of the rallies gaining back over 100%.
  • We currently still think the next 5%-10 move in the stock market is higher
  • CNN’s Fear and Greed Indicator currently has a reading of 11 on a scale of 0-100, which indicates extreme fear with 6 out of 7 of its individual components registering extreme fear. Only the volatility component is at neutral.

Several of our 17 technical metrics flashed oversold during the lows on the S&P on Friday. Unfortunately, the late day rally negated most of those oversold metrics which require a closing oversold condition for more certainty of a bear market rally.

But we believe the next 10-15% move in the stock market is lower. A recession combined with inflation above 3% is now our base case for 2023 with a 30-50% drop in the S&P from peak to trough. 

Since World War II:
  • Inflation (CPI) over 5% has preceded a recession every time. It is now over 8%.
  • Oil prices doubling relative to the prior 2 year average ($54 in this case) has preceded a recession every time. Oil at one point breached $120 and is still over $110.
  • 10 of the 13 prior recessions have been preceded by a tightening cycle by the Fed. We believe rates will be closer to 4% before this tightening cycle is over versus just 1% at the high end today.
  • 10 of the last 13 recessions have been preceded by the 10-year yield going below the 2-year yield. This occurred on 4/1/22 and was -7 bps.​
Any one of the above has a great track record in predicting a recession but all of them have now occurred. During the prior 3 recessions that also had high inflation from 1968-1982, the S&P dropped between 27-48% on a price basis.

​Additionally, during high inflation environments, the trailing PE for the S&P is much lower than average: 
  • From the 1972 peak to 1974 trough, the trailing PE went from 20x to 7x as CPI rose from 2.3% to 12.7% with the S&P losing nearly 48% from peak to trough. 
  • For nearly the last 70 years, whenever CPI has been above 3% the trailing PE has averaged 15x. Whenever CPI has been above 5%, the trailing PE has averaged 12x. 
  • Despite the CPI at 8.3%, the trailing PE today is 20x which we hope will only compress to ~15x at its low point. 
  • For the first time since the Volcker led Fed of 1980s, the Fed is your enemy and will likely unwillingly force the economy into a recession to slow inflation.​
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We believe that the key to building long-term wealth boils down to avoiding crushing losses. Following the 48% price decline in the S&P that started in early 1973, it was almost a decade before the S&P stayed above that level. Therefore we focus on capital preservation and steady performance over-time that is minimally correlated to the stock market.

On a positive note, we believe there will be an incredible buying opportunity at some point in 2023, particularly for technology names when the market hits its ultimate low for this down-cycle during the next recession. In the meantime, all the best to you and your family during these challenging times.

Sincerely,
Dan & the Satori team
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    Dan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund. ​

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