3Q 2022 – The Bear Market Resumed and Head Fakes Abound
What a wild year it has been so far. While this is technically our 3rd quarter letter, we will provide an update on several important things that have occurred so far in the 4th quarter.
In summary, year to date through the 3rd quarter, the stock markets around the world experienced their worst decline since the Global Financial Crisis. The global index was down ~25% and U.S. stocks have dropped precipitously, with the S&P 500 (“SPX”) down ~26% and the NASDAQ down by nearly ~33%. Some sub-sectors have dropped by more than 50% and a few have even been eviscerated with 75%+ implosions. The negative performance of the SPX in the first nine months has only been exceeded by the Depression of 1931, the collapse of the Nifty-Fifty in 1974, and the bursting of the Tech Bubble of 2002.
But what has really been the story this year is that bonds have not only failed to provide protection, but they have also added materially to investor’s’ pain. The U.S. 10-year Treasury Bond has generated a Total Return of -17% so far this year, which is the worst performance in history. In fact, the typical 60/40 stock/bond portfolio has just experienced the 2nd worst performance of the last 122 years…Quite simply, there have been very few places to hide.
In spite of the immense pain experienced by investors, they have continued to want to be optimistic, as that is human nature… until it is not and panic sets in… We have seen three rallies of at least 10% so far this year, all which have occurred with lightning speed and ferocity. Such is normal in a Bear Market. But, as we discussed last quarter, most of these rallies tend to be fool’s gold:
When the reader sees the compression of valuations and the growing expectations that earnings will be more challenged, they would not be blamed if they expected to see a sharp stock market decline in July and August. But they would likely be quite surprised to learn that stocks actually rallied dramatically. As a matter of fact, the rally in the S&P 500 was nearly 19% from the June lows to the time of this letter on August 15th. How can that be? Quite simple, and textbook when one studies history. Obviously, anything can and sometimes does happen, but this feels like nearly every other “bear market rally” that has been seen over the last 120 years. Most people do not realize it but some of the most extreme rallies in stock prices have occurred in the midst of a bear market.
With that said, it is important to note that every bear market will end, and stocks will usually rally long before the actual trough in earnings and the economy. Yes, that could theoretically be happening here as the market is definitely a “forward looking animal.” That just does not feel like what is happening today, as this feels a lot more like “hope” than a forecast of the cycle turning. (And as we have stated many times over the years, “hope is not a good investment strategy…”)
So that no one can misunderstand how we feel, we are of the opinion that we have been in the midst of one of the biggest “sucker rallies” of history. We saw it multiple times in 2008, 2002 and 2000 and they tend to feel the same, with a combination of short covering and “don’t miss out” buyers. Obviously, this time can be different but with the Fed tightening, no fiscal stimulus on the horizon, a hostile and rapidly deflating China, continuation of the war in Ukraine and a massive energy crisis in Europe, etc., it is really hard to paint a bullish picture.
Indeed, after the rally was halted within days of us writing that letter, the decline was ferocious, and the SPX dropped by more than 18% over the next eight weeks. Investors seemingly woke up to the reality that the Federal Reserve was not kidding and that they were going to continue to raise rates at a breathtaking pace. From there we have again experienced a 13+% rally, primarily because we got the first glimpse that perhaps inflation might slow. The markets celebrated that the Consumer Price Index only grew at 8% over the last year… but that was better than 9%. Trying to explain the psychology of human behavior is sometimes easy, other times it is really hard, and occasionally it is downright comical. The markets celebrated that inflation was still running the hottest it has in nearly 40 years! All kidding aside, that single data point was better than what people had been afraid of, so the “hope” returned to the markets that the Federal Reserve might possibly, maybe, slow the speed of interest rate increases. Thus, the stock and bond markets celebrated, creating a bit of a short squeeze. Now things will get very difficult again for investors, as the fundamentals eventually must improve in order for there to be a sustained rally, so let us transition to what the fundamentals look like as we write this letter.
An Update on the Double Punch to the Gut
We have talked multiple times about how most major bear markets are caused by the “Double Punch to the Gut,” which is when there is BOTH valuation compression and earnings decline. Most of the decline in the first half of 2022 was due to valuation compression, and then the next leg of the decline was what we believe to be the first wave of earnings deterioration. That combination has caused investors to experience a vicious bear market of more than 25%. Therefore, we should provide an update on where valuations are and the outlook for earnings. A picture will save us a thousand words, so here is a chart of the Price-to-Sales (“P/S”) ratio of the SPX:
Source: Bloomberg. As of 11/18/22.
Naturally, a single metric is never enough to prove a hypothesis, but this particular metric is strikingly simple to observe, explain and understand. The P/S ratio is just the price divided by the sales of a company or, in this case, a basket of stocks. One can immediately see that the P/S has come down quite a bit over the last 9 months, but that we are still higher than the highest level experienced during the tech bubble and roughly triple the level of the lows suffered in 2009.
Let us look at a different metric for those who would state that sales do not matter as much as cash flow. We would readily agree with you, so a consideration of valuations compared to Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) would be in order. Here is a chart that illustrates where we are on that metric:
Source: Bloomberg. As of 11/18/22.
It is quite obvious that the same picture applies whether we are talking about P/S or P/EBITDA. We have seen improvement, but we are still trading at higher valuations than even was achieved during the Tech Bubble.
Those metrics provide a simple but powerful comparison, but they both do not account for the level of interest rates and that is a critical component today. So, for those that want something a lot more technical, let us compare the Earnings Yield of the SPX with that of a 2-year U.S. Treasury Note. This chart, from our friends at Piper Sandler, has a lot going on and we will explain it below:
At the top of the chart is the SPX Earnings Yield. We do not have the space to do an exhaustive explanation but the easiest way to think about the Earnings Yield is that it is the inversion of the Price to Earnings Ratio (“P/E”). As an example, if the SPX was trading at a P/E of 20x, then the earnings yield would be 5% and if the SPX was trading at a P/E of 10x, then it would have a 10% earnings yield. As one can see in the top of the chart, the Earnings Yield has gone up on the SPX since the low in early 2021, from nearly 3% to now more than 5%.
The middle of the chart shows the yield of the 2-year U.S. Treasury Note (“2yr”), which since early 2021 has gone from basically zero to ~4.5%.
The bottom of the chart shows the ratio ofdifference between those two yields, compared to each other. At the depths of the sell-off in the SPX in the middle of Covid, while at the same time bond yields plummeted from the Federal Reserve stimulus, the spreadratio was ~6.5%x. That means if you were buying stocks at that time, you were getting paid a yield of more than 6.5% abovex what you would get if you bought the 2yr. Fast forward to today and that spreadratio is now less than 0.75%x… What happened!? Quite simply, the 2yr has gone from basically zero to 4.5%…!
One may ask, “so what, all I care about is if stocks are cheap or not?” Unfortunately, as we discussed in previous letters, there are very few professional investors who were managing money the last time this yield dynamic was a real problem for stocks. At the end of the day, EVERY asset is priced off the risk-free interest rate. Investors have choices to make, and they will choose what they feel is best for them based on the risk/reward they are willing to experience. For an abundantly simple example think about it this way., Iif someone came to you tomorrow and said you can buy a U.S. Treasury Bond that is backed by the full faith and credit of the massive printing press that is our government, and that it would pay you 20% a year for the next 20 years, would you buy it? Yes, you likely would! Why would someone take a lot of risk investing in something else if they can get a “risk free” return like that? (Yes, we know we are ignoring purchasing power and inflation in this simple analogy…as that is what makes it simple.)
The same concept applies across all asset classes, as investors choose where they want to be on the scale of risk/reward. In real estate, it is called a Cap Rate. In stocks, it is called a P/E. In oil and gas, it is PV, etc. Ultimately, no one wants to take a risk unless they feel they are going to be paid for taking that risk.
That means that as the risk-free rate of interest increases due to the activity of the Central Banks around the world, all other asset classes have to compete with the risk-free rate. The way that manifests itself is that assets either perform much better, or the prices of those assets get cheaper. Guess which usually happens? Indeed, prices come down until assets reflect an appropriate Risk Premium and then investors will buy them.
Before we move on, valuations are just one factor in the “double punch” to the gut. The other is earnings and, as we have discussed in the last three quarterly letters, we are very concerned on that front, and those concerns are being manifested. Quite simply earnings are dropping, and the estimates are beginning to forecast an acceleration in the rate of decline. Here is a chart from our friends at Piper Sandler:
The reasons for the decline in earnings are quite logical, such as the slowing economy, margin compression from inflation pressures, etc. One can immediately see that the SPX tries at times to ignore the earnings picture, and at some point, it will begin to look on the other side of the recession, but right now it appears the latest rally has been yet another “hope fueled” buying spree.
Back to the Earnings Yield chart above, especially considering the evidence that earnings are beginning to decline. What that chart clearly shows is that right now investors are being paid very, very little to purchase the SPX compared to just buying the 2yr. This will only be reconciled via one of three possible changes; 1) the SPX earnings grow dramatically 2) the 2yr yield stops going up and/or drops in a material way, or 3) the SPX price drops a lot… Naturally it can and likely will be a combination of all three. At some point the Federal Reserve (“Fed”) will stop raising rates and begin to lower them. Unfortunately, that is likely to only occur when the economy is in a material slowdown. But that means that SPX earnings will likely decline in that slowdown, exacerbating the problem and the mismatch of this relationshipratio. One can quickly see how these situations are rarely solved easily. In 2020, it was solved by the massive stimulus from the Fed and a rapid snap back in SPX earnings, but that was definitely a rare exception in history. In this case, the mismatch is likely reconciled by a combination of lower stock prices, a stabilizing earnings picture on the other side of the recession, and the Fed beginning to reduce interest rates. When could all those stars align? It is anyone’s guess, but we can make a pretty good case for why it will be the fall/winter of 2023/2024. Stay tuned…
An Update on the Ultimate Recession Indicator
First, a refresher of what the Yield Curve is:
The Yield Curve is Predictive – The shape of the yield curve is one of the most accurate predictors of the future that exists in all of investing. If there is one economics concept that investors should understand, this is it… The yield curve is the difference between short-term interest rates and long-term interest rates, and it is a reflection of the collective market view as to the economic growth that is expected. Normally the yield curve is “steep”, meaning that bonds that have a short time to maturity will trade at a lower yield than the bonds that have a long time to maturity. Why is this? It is because investors usually want to receive more yield if they are going to tie up their money for a long time. The yield curve is “flat” if short-term and long-term rates are basically the same. An “inverted” yield curve is where short-term rates are actually HIGHER than long-term rates. Investors are willing to accept a lower yield on longer dated bonds, because they expect yields to drop significantly from a slowdown in the economy. You may ask, how accurate is the yield curve as a predictor? Quite simple, it has been 100% accurate since World War II. Every time the 3-month U.S. Treasury yield has been higher than the 10-year yield, we have experienced a recession in the following 6 – 18 months.
We have talked about how the inversion of the 2-year spread vs. the 10-year has been growing, so here is an updated chart that shows how we are now more inverted than any time in the last ~40 years:
But we also said in the text from last quarter that there is a spread that has never been wrong, and that is the 3-month vs. the 10-year. It had teetered on inversion for a while but not yet gotten there. It has now become inverted:
A recession is either already here or it will be here soon. We could put dozens of additional slides in this letter to illustrate why, but suffice it to say, it is upon us.
One could ask what caused this massive shift in the shape of the yield curve, and the answer is quite simple. The Fed has been raising rates at a nearly unprecedented velocity. This chart is quite shocking if one is a student of history:
We could go off on a tangent about how in the world the Fed was still claiming that inflation was “transitory” until the beginning of 2022, but we will avoid that and let it be debated in the history books. For us, all that matters is that the Fed has taken extreme measures to try to tame inflation and that is having, and is going to continue to have, an impact on all asset classes.
What has gotten a lot less attention, but that we think investors are ignoring at their own risk, is the changing dynamic of the Fed’s balance sheet. In response to Covid, the Fed pulled out nearly all stops to stimulate the economy, creating a skyrocketing effect on their balance sheet, as illustrated here:
It may be hard to see, due to the immense scale of the increase, but on the top right of the chart one can see that the balance sheet is beginning to shrink. An additional chart, from our friends at Holowesko, paints a clear picture as to the action being taken by Central Banks around the world:
The Fed has made it very clear that is what they intend to do, and investors would be wise to consider the impact. In order to make that impact tangible, we will add another very complex chart:
Source: Wall Street Research.
Note: Based on latest data available on October 28, 2022.
While that chart illustrates a lot of details, the key takeaway is how correlated the return of the SPX is to the M2 Money Supply. So there is no confusion; rising M2 = Good… falling M2 = Bad!
Further, this can all become the backdrop for how history does not always repeat itself, but it does tend to rhyme… We are not saying that this is 2008/2009, as every bear market is different in so many ways, but the correlation between the performance of the markets this year to 2008/2009 has been quite startling:
To repeat, we are not forecasting a drop in the SPX to 1600, as would be inferred from this correlation continuing. But we are also not saying it is impossible. IF we saw the Double Punch to the Gut really take hold, with a 20%+ drop in earnings and a material decline in the SPX P/E, it is plausible. And that should cause investors to reassess their allocations to be sure they are comfortable with their risk level.
We continue to believe that investors should be very cautious and have material protection in place. For the third time this year, we did change the CAZ Scale. During the excessive panic moments in early October, valuations in some pockets of the market became relatively attractive. That sharp decline in valuations caused us to adjust the CAZ Scale to a 2, and to put a fair amount of capital to work, but then the blistering rally in late October/early November caused us to go right back to a “1” on the CAZ Scale, and we strongly believe that the risk/reward from these levels is not favorable. For total clarity, we do not typically adjust the scale very often, but the volatility in valuations this year has not been typical…
What you can infer from the rapid movements is that we are not far away from an improved outlook, and it is quite possible that “Santa Claus” may come in the 4th quarter. We always want investors to remember that the CAZ Scale is NOT a market timing tool but is designed to let investors know what we feel about risk/reward. Today is still the day to play defense, with much more attractive opportunities available in the private markets, but there will be a day when it will be time to play offense. When that time comes, we will let you know how we are positioning our personal assets to take advantage of the opportunities and will invite you to come alongside our families.
We have been waiting to finish this letter until we got the results of the mid-term elections. It is hard to believe it took this long. Even as we write this on the 20th of November, we still do not know for sure the results in numerous elections around the country. (That itself is a sad statement, that one of the most advanced countries in the world cannot figure out how to determine the winner in an election in a few hours, much less a few days…) What we can say at this point is that it appears that the Republicans have taken control of the House of Representatives. The results so far indicate that they will have at least a nine-seat advantage, but it will certainly still be a very split chamber, just like the Senate. At this point, with results still pending the runoff in Georgia, the Democrats will continue to have control of the Senate via the Vice-President’s tie breaker, or they will have a single seat advantage. No matter how the dust finally settles, all signs point to “gridlock,” where each major party controls at least one of the chambers of Congress or the White House. Markets generally like gridlock, as there is a very low probability that any drastic changes to policy will be enacted that could throw investors a curve ball.
Speaking of curve balls, we are very proud of our hometown Houston Astros for winning the World Series, not just because it is our hometown team, but also because we are part owners. That is also true, from earlier this year, for the NBA champion Golden State Warriors. It is very exciting to own stakes in two world championship teams, and to provide that same opportunity to our investors.
As we wrap up this letter, which has become much longer than normal because of the pivotal point in which we find the world, we want to be sure that everyone saves January 19th, 2023 on your your their calendars. We will host our Themes for 2023 event live in Houston that day, and we would strongly encourage you to make it a priority to join us. We will have a full day of discussion with our partners in most of our major themes. When the invitations are sent Current Partners will have first priority for approximately a week, and then we will open it up to the rest of our ecosystem, so please be sure you register as soon as you receive the invitation. We expect to be on a waiting list again this year, and we want you to be able to participate.
We hope you have spent time in our new investor portal, InvestorFlow. The feedback thus far has been outstanding, so we feel like two years of hard work has been worth it! We continue to look for talent to add to our Team in every department, so please send us every elite performer you know that has at least a few years of business experience. If they are talented, we will find a seat on the bus for them. Most of the roles are based in Houston, but some of the investor relations positions can be located in other geographies. Please have all potential candidates email us via firstname.lastname@example.org.
Thank you for the confidence that you place in our Team. We are grateful for your partnership, and we hope everyone has an outstanding holiday season. We look forward to seeing you on January 19th, if not before. All our very best!
The CAZ Investments Team