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).
The big S&P/Nasdaq rally of 9%/12% in July was due to
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).
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 (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 (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.
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.
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
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 $0.40 if Microsoft hadn’t changed the depreciation life on their cloud infrastructure from 4-6 years. With 93% of the Wall Street analysts having a buy rating on the stock, it is not a surprise that this was not highlighted. We lost ~5 basis points for the month of July on our Microsoft short but being short Microsoft has been a great profit generator for the year. We plan to increase our Microsoft short position in the future. When accounting changes are used to cushion a blow to earnings, we always get concerned. At a 30x PE with their PC end market slowing, we believe risks are not properly discounted.
Speaking of the PC market, we sold Intel before the print given our vocal concerns over the PC market being a pandemic beneficiary. We had owned Intel along with TSMC ($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
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.
We have no position currently and are evaluating the incoming data.
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.
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.
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.
We believe this is yet another bear market rally
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.
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.
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,
We are removing Google from our Top5 Picks for 2022 and recommend investors stay in cash. As a result of their greater market share of the total ad market today, we believe estimates for advertising based internet companies like Google & Facebook are more at risk than is commonly believed.
In 2021, Google reached $258B in revenues (29% of ad industry rev) while Facebook was $118B (13% of total ad industry rev) with digital ad spending in total have grown from 12% share to 2/3rds share of the total $900B ad market over the past 12 years.
During the Great Recession of 2008-2009, Google revenue was only $24B or 3% of ad industry rev while Facebook at $777M was 0.5% in 2009. Both companies were able to grow during that downturn as the internet was gaining momentum as an advertising medium with only ~12% of ad spending online.
But both traditional and digital ad spending is likely to get hit over the next 18 months during a recession. During the 2008-09 Great Recession, US ad spending declined by 6% in 2008 and by 18% in 2009. This decline for two consecutive years last occurred in 1940. Digital ad spending, however, was up slightly in 2008 and down only mid-single digits in 2009. I believe history has skewed peoples view of the resiliency of the online ad market. Google in fact saw revenues increase by 31% in 2008 and by 9% in 2009 as the internet economy gained share. The much smaller Facebook saw revenues grow 78% in 2008 and 186% in 2009.
The launch of the iPhone in January of 2007 also helped shift viewing habits online as you could essentially surf the internet from anywhere versus from just your PC. This drove even more ad dollars online despite a recession.
We thought Google should have been able to outperform the overall market even during a down 30-50% decline in the S&P during a recession given their prodigious cash generation, reasonable market valuation and focus on future innovations. However we believe the dollars available to all online ad companies going forward including Google will also be less than we originally thought due to share gains over the near-term at:
1) TikTok (~$4B in revs in 2021 and projected to do $12B in 2022),
2) Amazon ($31B in ad revs in 2021 & up 33% in Q4 as it ramps its focus on their ad business)
3) Apple (~$4B in ad revs and up over 3x in 2021 driven by privacy changes)
4) Netflix (coming before year-end which could be a big drain in ad dollars given they have over 20% of US streaming audience share).
Netflix on the margin tipped it for us with our Google recommendation as some people will switch to a cheaper ad supported tier during a recession. Netflix has 222M global subscribers currently. That is a fair bit of ad inventory that could potentially be added to the market. We have already seen the damage TikTok has caused at Facebook.
Finally, with the world slowly opening up, people are spending time away from their screens as they go engage in leisure & travel activities. This will cut the amount of time consumers are on the internet and reduce monetization opportunities for Google.
In summary, as a result of our belief in 1) an impending recession, 2) online advertising share gains at TikTok, Amazon, and new entrant Netflix, and 3) less time spent by consumers online as they engage in travel & leisure activities, the ad sector (both traditional and online) is an area where we have short positions currently. We think street consensus of 34% revenue growth at Google and 22% at Facebook over the next two years is optimistic to say the least.
At some point in 2023 when the market hits its ultimate bottom, Google will be one of the first names we buy for the long-term given their culture of innovation, solid cash generation and reasonable multiple compared to their long-term growth potential.
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:
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:
Additionally, during high inflation environments, the trailing PE for the S&P is much lower than average:
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.
Dan & the Satori team
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).
“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,
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.
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.
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%.
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.
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,
We are writing this article to more fully flesh out our comments on CNBC on Friday (1/21/22) and subsequent questions that we received.
Human beings are wired terribly for investing. The tendency is to buy at highs given greed and to sell at lows given fear. Last week had the largest weekly drop in the S&P in nearly 2 years. We covered essentially all of our shorts by the end of the week. This is despite having more shorts than longs earlier in the month given our belief in a 20% correction in the S&P. We also invested 15% of the assets in the fund on Friday and used available cash in the fund to do it. However, we still have a large cash position remaining. Remember that cash was one of our Top 5 Picks coming into the year.
So why did we cover our shorts and put cash to work? We use technical tools to essentially protect ourselves from our normal human emotions and to statistically up the odds of achieving better risk adjust returns.
From their all-time record highs, the Russell 2000 is down 19% from 11/8/21 while Nasdaq is down 15% from 11/22/21 and the S&P is down 9% from 1/4/21. We used available cash sitting in the fund on Friday (1/21/22) to put 10% of the portfolio into a small cap basket & 5% into regional banks (-9% in 4 days). 31% of our 17 technical indicators were near-term oversold. We prefer this closer to 50% but some of our favorite indicators are at oversold levels. For example, the VIX (fear gauge) curve is now negative indicating investors are willing to pay more for near-term protection than longer-term protection. The selloff was also on volume that was ~60% above the 20-day average. There were more puts being bought than calls while typically ~40% more calls are bought than puts. The TRIN ratio which is the number of advancing/declining stocks (Advance Decline Ratio) divided by advancing/declining volume (Advance Decline volume) was ~1.5 versus an average of 1.1 over the past five years. This indicates a lot more urgency in the selling of stocks going down than the buying of stock going up. 51% of the S&P hit a new four week low. Despite our belief that the next 3-5% move in the S&P is higher, we believe the S&P is still ultimately down at least 20% from peak to trough due to persistently high inflation, an aggressive Fed & slower growth. (See our post on 12/28/21 for detailed reasoning.) We plan to put our shorts back on at higher levels.
Two of our larger remaining technical concerns are: 1) close to half of the worst one day crashes in history have happened on a Monday typically following a bad week ending on a bad Friday which is what just happened, and 2) the VIX closed at 29 which is below the 40 threshold we prefer to see.
Rallies within brutal bear markets are common and we hope our technical indicators help our shorts avoid the worst of these and enable us to buy longs at statistically favorable times. We have analyzed eight different bear markets but would note the statistics for the following periods which we think have similarities to the current period of time. During the Global Financial Crisis, the S&P had 11 rallies in the S&P that averaged 10% while there were 12 declines averaging 15% over nearly a year and a half. The total price decline was 57%. During the Tech bubble bursting, the S&P rallied 7 times averaging 14% while falling 8 times averaging 17% over 2 ½ years. The total price decline was 49%. And finally, over nearly two years in the early 1980s when Fed chairman Paul Volcker was fighting inflation, the S&P rallied 7 times for 8% while dropping 8 times for an average of 10%. The total price decline was 27%. This in our view is the most comparable bear market. Even during the one month 34% sell-off during covid in early 2020, there were 4 notable rallies that averaged 7%, but given 3 of them were one day moves, we do not believe they are as relevant.
In summary, we think we are close to a near-term low and wanted to reposition to take advantage of that in both our short and long positions. For those that want to stay focused on the long-term and do not have the time to manage your investments daily, we think the lows for the market still lie ahead.
At the end of every year, I try to look back at some of the biggest mistakes to learn from them. Viacom ($VIAC) is certainly one of those. I have also received many requests on social media for an update on my thoughts and at times 280 characters can be a bit too restricting.
RECAP of $VIAC
Back in 2020, I talked about VIAC being a more value centric way to participate in the excitement around streaming. VIAC’s stock surged and reached $100 on 3/22/2021 from $37 to start the year. In hindsight, much of the move in this name was driven by relentless buying by Archegos Capital Management, a ~$20B hedge fund. VIAC’s stock quickly retraced those moves as an extremely well-timed capital raise by VIAC and the high-profile liquidation of Archegos drove VIAC’s stock down to an intraday low of $40 on 3/26.
To us, this move lower created a very interesting buying opportunity which we talked about subsequently on air. But as of year end the stock is even lower at $30. So, what happened?
Fundamentally, VIAC rev expectations have been drifting up through 2021 driven by streaming revs that have also been going higher. Given the losses in Viacom’s streaming business, this has driven EBITDA and EPS expectations lower which is natural as they gain scale in streaming. As discussed later, streaming leader Netflix (NFLX) lost money for eight years before 2020 and should be cash flow breakeven in 2021. Obviously NFLX’s stock has done well over this time driven by subscriber growth, the most watched metric. But obviously subscriber growth did not help VIAC’s stock price this year. So what happened?
In our minds, there were two main driving forces after the Archegos meltdown that drove VIAC’s stock price even lower: 1) the leaders in the streaming space started missing their subscriber expectations and 2) treasury yields started to rise this year creating a greater focus on profits versus just growth.
Driving Force 1:
Dan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund.