“When the facts change, I change my mind - what do you do, sir?”
John Maynard Keynes
As we entered 2022, we said on our CNBC interview on 12/29/21 that the S&P “down 20% is very likely at some point during the year if not more” despite the S&P hitting new all-time record highs. This view combined with flexible thinking allowed us to make money in 2022, while many funds struggled.
When thinking about my top picks for 2023, the first thought that came to mind was how volatile this upcoming year could be. There are many potential variables, both positive (eg. potential peace in Ukraine, China exiting zero Covid, Japan exiting yield curve control) and negative (eg. higher than expected wage inflation, real-estate implosion, tech demand slowdown) that are changing at a rapid pace. The speed and impact of these constant changes on the market brings to mind the investing environment of the Global Financial Crisis and the Tech Bubble.
Whether it is inflation numbers, growth data, or large market moves, each new piece of information requires me to evaluate my current position and adapt. To paraphrase Charles Darwin in the Origin of Species, “It is not the most intellectual or strongest of the species that survives, but the species that is best able to adapt and adjust to the changing environment in which it finds itself.” This focus on flexibility on a DAILY basis has helped us to generate positive returns in 2022 for my Satori hedge fund while others of my species died.
In summary, my two overarching investment themes from 2022 remain for 2023:
The reasoning behind these two investment themes is the persistent issue of inflation staying higher than expected, which is the #1 enemy for the Fed and consequently your investment portfolio. 55% of core PCE inflation (the Fed’s preferred measure) is services excluding housing, which is driven by wages increases (AHE +5.1% y/y). These wage increases are being driven by the 1.7x more job openings (10M+) than unemployed (6M+). While we are hearing a lot of headlines from big tech names laying off employees, it is important to remember that over 75% of jobs in the US are not from public companies. As a result, you will probably need a hard recession to kill 4M "excess" jobs to drive down wage inflation.
What does a recession mean for the stock market?
A bear market performance for the S&P without a recession typically averages just under a 30% loss. The S&P declined 25% from its peak on January 3rd to its closing low on October 12th.
If in 2023, we do not get a recession or it is mild, we may have seen the lows already for this downturn. However, we do think we will get a recession and it is likely to be closer to severe given there are 4M “excess” job opening that will need to be destroyed to get wage gains under control.
A bear market that is accompanied by a recession typically results in an S&P decline of over 40%, indicating that we have not seen the lows for this downturn yet. 3000 is our single point estimate on the S&P in this scenario with 2400 being our downside case.
Our Top 5 Picks for 2023 are:
Given our expectations of the S&P hitting 3000, these are hedged with shorts in:
We expect initial guidance to be horrible for 2023 when companies report poor Q4 results, especially in the technology sector. For example, we think it is likely that high profile stocks like $AAPL will pre-announce negatively in the first week of January. In a similar vein, we expect $TSLA to miss Q4 delivery expectations. How the market and these two stocks react to these events will determine how we position for Q1 results. Do we get another bear- market rally to start the year or do we head back to the lows in October driven by poor Q4 results?
We actually bought $TSLA on the long side for the first time since 2019 in December. We made money on both our short and long position in 2022 though we do not own it currently.
We believe demand will take another step lower between now and the end of 2023 given
There are also negative tail risks from
There are only two drivers that determine the price level of the S&P, earnings and the multiple applied to those earnings. Multiples began to contract early in 2022, with earnings estimates peaking in June and then starting to decline for the first time in two years. Looking at the behaviors of these drivers both historically and presently has been a major factor in our thought process when evaluating how early 2023 will look.
Multiple contraction due to rising interest rates has primarily driven the drop in the S&P up until now. The S&P trailing PE peaked at 32.3x in March of 2022 and it is now 18x.
But, during high inflation environments, the trailing PE for the S&P is much lower than average:
Based on this data, we believe that reductions in S&P earnings estimates and further multiple compression will drive the next market move lower. Earnings estimate reductions started for the first time in two years with the Q2 earnings season results and Q3 guidance. The EPS in 2021 for the S&P was $193. The estimate for CY22 is for EPS to expand to $219, which is down from the prior estimate of $229 before the Q2 earnings season. Similarly, the estimate for CY23 is for EPS to expand to $234 in 2023, which is down from the estimate of $252 at its peak in June before Q2 earnings.
We think the estimate for CY23 will eventually be closer to $200 from its peak of $252 when looking at earnings reductions during prior recessions. In 2022 these estimate cuts led to drops in the stock market and we believe the same will hold for 2023.
Our single point price target for the market bottom on the S&P is 3000 derived from 2023 S&P EPS of $200 with a 15x multiple. At the low end we can see the S&P reach 2400 based on a 12x multiple which is not unreasonable at inflation levels above 5% historically.
However, it is important to note the decline downwards is rarely a straight line, as rapid and significant rallies in the S&P often occur during bear markets. While the S&P went down 49% during the tech bubble and 57% during the Global Financial Crisis, there were five rallies between 18-21%. Each time, people were quick to call the bottom despite the fundamentals still getting worse. To put this in perspective, the compound annual price return for the S&P over the past 70 years is under 8%.
Even during 2022, we saw the S&P rally seven times with an average gain of 9% while it finished down 19% for the year on a price basis.
With so much complexity and volatility in today’s investing environment, how should investors be positioned to start the year?
TOP 5 PICKS FOR 2023
#1) CASH IN 3 MONTH TBILLS
#1) Cash - This remains our favorite investment in 2023 just like it was in 2022. While the singular focus of my fund is to maximize reward while minimizing risk by trading the market daily, not everybody can trade daily. Particularly for those of you who cannot trade this market daily, cash is king. Sitting on cash allows us the flexibility to reinvest if the S&P goes lower in 2023. Rather than guessing whether stock prices have gone down enough, cash allows us to wait for the fundamentals to bottom and make calculated investments that maximize reward while minimizing risk. Moreover, that cash can also be invested in 3-month treasury bills earning about 4.3% per annum to start 2023 versus just 0.03% to start 2022. You are essentially being paid for your patience to wait until the risk to reward is in your favor.
#2) $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. When the S&P dropped 37% in 2008, the healthcare sector dropped 23% while the riskier S&P biotech subsector dropped 8%. Over calendar 2000 & 2001, the S&P dropped 19% over this 2-year span, while the healthcare sector gained 22% and the biotech sector gained 19%. In 2022, the S&P dropped 19% while the XLV dropped only -4% while the XBI was down a hefty 26%.
On a single stock basis, we are interested in companies focused on obesity, Alzheimer’s, and cancer. However, many of these names have already performed relatively well in 2022. Therefore, we believe the diversity provided by the healthcare ETF $XLV helps minimize this potential downside risk for the average investor. For those comfortable with a higher risk strategy, $XBI is our preferred biotech ETF given its greater than market drop in 2022.
#3) $URA - Commodities should continue to do well as a result of underinvestment in capacity expansion over the past decade. In particular, we like uranium, oil, and copper.
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 like to perform well and the $URA ETF is a great way to get diversified exposure to the space.
We like $USO for oil as The Strategic Petroleum Reserve is down to the lowest level since 1984. Beyond that, the Biden administration has initially talked about refilling reserves at around $70 although recently this changed to $80. This was a top 5 pick of ours to start 2022 and finished up 29%.
Lastly, we like $FCX to get exposure to “Dr. Copper” as it should benefit from the ramp in EV sales as the world moves to clean energy.
We like commodities in general as China, the world’s largest buyer of most commodities, now exits their zero Covid policy, but we think these spaces should benefit the most and $URA is our top pick.
However, picking the right entry price point for a commodity is essential for successfully investing. Unlike stock prices that can go up infinitely, commodity prices operate more cyclically. High commodity prices destroy demand, which then lowers that commodity’s price, which in turn helps increase demand.
#4) $MUFG - Japanese banks should be significantly more profitable as their treasury yields go higher. On paper, shorting Japanese government bonds (JGBs) over the past two decades made sense as government debt exploded higher. However, the Bank of Japan (BOJ) continued to cut rates to below zero as deflation was their main enemy while at the same time buying JGBs. These two behaviors in tandem were the primary drivers that allowed JGBs to soar higher despite fundamentals suggesting otherwise. As a result, shorting JGBs was commonly referred to as “the widow maker trade.”
As of late December, we think that trend changed. The BOJ finally seemed to acknowledge rising inflation by loosening their yield curve control. At the same time, they raised their inflation forecast to 2.9%, the highest annual rate since 1989. As a result of these changes, we believe rates will eventually rise, especially with the appointment of the next head of the BOJ in April.
With this looming change in mind, we believe that buying Japanese bank stocks presents a potential opportunity for equity investors. For two decades, Japanese banks have had to contend with JGB 10- year yields consistently below 2% and occasionally straying into negative yields. Since listing in Japan on April 2nd of 2001, 8306.JT (Mitsubishi UFJ Financial Group) is down 27% while the Nikkei is up 102% & the S&P is up 235%. However, this December saw JGB 2Y yields turn positive for first time since 2015. Therefore, Japanese Banks should now be finally able to make decent money lending. To position our own fund for this opportunity, we own a basket of names including Mitsubishi UFJ Financial Group ($MUFG) which is the ADR of Japan’s largest bank.
#5) $META - Meta looks to be a solid long as we believe the stock is undervalued relative to what it should be. We think the biggest contributor to Meta’s undervalued stock price is how much money they are spending, which has negatively impacted the company’s valuation, as it trades at an 11x CY22 PE vs the S&P at 18x and the largest internet advertising-based company, $GOOGL, which trades at 17x.
We would also note that META has suffered arguably more than any other company from:
However, Meta’s Instagram Reels product (which competes with TikTok) went from an annual run rate of $1B in revs in their June quarter to $3B in revs in the September quarter of 2022, with user growth and engagement remaining surprisingly solid.
Moreover, the spending that offsets META’s earnings, particularly spending on the Metaverse, is fully within their control to regulate. Their recent actions including cutting spending plans just two weeks after giving guidance indicate that future spending will have more scrutiny going forward.
While we are wary of tech stocks in general, particularly those related to advertising spending (which declined over 20% during the 2008/09 recession), META is worth owning on the long side. The stock is down nearly 70% from its highs and Meta may be one of the few companies that sees its multiple expand while multiples for the market decline in 2023. But both $DIS and $NFLX starting an ad supported streaming tier in Q4 will take away online ad revenue dollars from existing players including $META. As a result, we are hedging our risk by pairing a long position on Meta with short position in online & offline advertising related companies with higher valuations.
My General Investment Strategy & Outlook for 2023
To decide whether my investment advice is suitable for you, I believe it is important that you understand my investment style. My goal is to produce good RISK ADJUSTED returns while minimizing downside risk during periods of severe stock market declines. In keeping with this principle, our net exposure (% of fund invested in long positions minus % of fund invested in short positions) has averaged just ~25% over the lifetime of the fund but produced over 80% of the return of the S&P.
Our end goal is to be greedy long term. It is easy to take on enormous amounts of leverage/risk and speculate on meme stocks, crypto, concept/innovation stocks and other volatile sources to make enormous short-term returns in a bull market. However, the risk of losing multiple years’ worth of returns when the market turns is extremely high. At the Satori Fund, we emphasize disciplined risk adjusted investing to ensure that investors not only are protected, but can even profit in both bull and bear markets.
For example, on a total return basis including dividends:
The math behind our philosophy is simple: if you lose 50%, you must be up 100% to get to even. Therefore, risk management is crucial to ensure long-term success. Having come off a 13-year-old bull market fueled by unprecedented fiscal and monetary stimulus; risk management is going to become ever more important as we move forward.
Our commitment to our principles of risk management and disciplined investing has allowed us to consistently succeed against the Hedge Fund Return Index while many other hedge funds have come and gone. As of now, we have almost doubled its return since our inception over 18 years ago.
When I can, I try to update major changes to my thinking that I can disclose on Twitter under @DanielTNiles with more expansive thoughts on my website danniles.com.
For those of you who want all the information available including fund performance, we can only disclose this if you meet the government criteria for being a “qualified or accredited investor.” Please go to https://invest.thesatorifund.com/register to see if you qualify or use the following button below.
All the best for you and your investments in 2023,
Dan & the Satori Team
Performance Disclosure Notes
Performance data quoted represents past performance and is not indicative of future results. Current performance may be lower or higher than performance data quoted. Performance data shown (a) is calculated net of all fees and expenses, including an incentive fee accrual, (b) assumes the reinvestment of any dividends and distributions and that investors are eligible to participate in the profits and losses from New Issue securities pursuant to FINRA Rules 5130 and 5131 since inception of the Fund, and (c) is not audited, although the financial data upon which it is based is subject to an annual audit. Actual performance for an investor may be materially different as fees and performance may vary depending on factors such as timing of investment and eligibility to participate in New Issues. Performance results may reflect expense subsidies and waivers in effect during periods shown. Absent these waivers, results would have been less favorable for certain periods.
Index performance quoted is shown for illustrative purposes only, does not represent actual Fund performance and is not meant to forecast, imply or guarantee future Fund performance. An index is unmanaged and cannot be invested in directly. Performance data for the indices is gross and does not reflect any deduction for fees, transaction costs or other expenses that an investor would pay if invested in the Fund directly.
Other Important Facts
The Fund is part of a master-feeder structure whereby Satori Fund I L.P. (a Delaware limited partnership) and Satori Fund, Ltd. invest as a “feeder” in Satori Master Fund Ltd. (the “Master Fund”), a Cayman Islands exempted company.
Pursuant to an Advisory Agreement (the “Advisory Agreement”), the General Partner has retained STP Investment Partners, LLC (“STPIP” or the “Investment Manager), an affiliate of the General Partner and SEC filed Exempt Reporting Adviser to serve as investment manager of the Fund. STPIP is a Pennsylvania limited liability corporation. For more information including organizational chart for STPIP please visit https://adviserinfo.sec.gov/firm/summary/306086
This document includes information relating to hedge funds that are exempt from registration under provisions of the Investment Company Act of 1940, as amended and other securities laws, including the Securities Act of 1933. As such, any shares or interests offered by such funds may only be sold through non-public “private placements” to qualified investors who meet certain net worth requirements and standards of investment sophistication.
Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Readers should not assume that any investments in securities, companies, sectors or markets identified and described were or will be profitable. Investing entails risks, including possible loss of principal.
The investment products mentioned in this document may not be eligible for sale in some states or countries, or suitable for all types of investors. Specific securities identified and described do not represent all of the securities purchased, sold or recommended for advisory clients. A list containing all recommendations made by the manager within the last twelve (12) months is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities.
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Investors like to look at data AFTER 1982 which shows the S&P bottoming before the Fed stopped raising rates. But that was during a period of lower inflation. During S&P bottoms in 1972, 1974 & 1982 during high inflation the Fed was already cutting BEFORE the S&P bottomed.
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
Dan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund.