Two Steps Forward, One Back – Currently Everything is Backwards
Here is where we are right now in the global environment:
Valuations Still very high
Monetary Conditions Tightening
Tech Adoption Slowing due to Covid pull-ahead
Globalization Negative (Russia, China etc.)
Supply Chains Improving a Bit but still tight
Energy Prices High
Politics Global Mess
Real Earnings Weakening
Interest Rates Low
Real Estate Prices Extremely Strong
Employment Easy to Find Work
Wealth Effect Neutral: capital markets down, real estate up
Overall the economic picture doesn’t look too bad. Work is easy to find. Construction, which is one of the biggest indicators of economic health, is strong. People are feeling rich as their houses are trading at stratospheric prices. For example, one person we know bought a house in Massachusetts in early 2018 for $609,000, and it is now worth $1.3 million. Wow. It takes them 15 years to save a $200,000 down-payment and now they made $700,000 in four years for doing nothing? In their own words: “we couldn’t afford to buy here now”.
Things are good for homeowners, but a disaster for renters. This should lead to more political turmoil and liberals calling for more equality – remember, equality is not good for capital markets – look at what has happened in China since Xi moved to a goal of “common prosperity” last year.
Unfortunately, bull markets always get a big valuation readjustment, and this time valuations are coming off insane record levels. Over the very long term (i.e. last 100 years), short term interest rates have averaged about 3.5%, inflation has averaged 3%, and stocks have traded at 16.7x earnings. So, with short term rates now at 2.5% (the 2-year yield is currently above this), you can expect the overall market to trade around 18-20x. Frankly, in this tighter liquidity environment, if your stock is trading over 18x 2022 estimates, then its higher risk.
Now is NOT the time to be buying higher risk stocks. Be careful about buying anything trading over 20x earnings and DON’T buy anything over 25x 2022 estimates. Avoid small stocks, avoid stocks without current earnings. Pay attention to valuation and don’t buy anything without earnings that are expected to grow.
Some very plugged in and intelligent investors are saying “this is a new Fed”. No its not. They have raised 25 basis points and it remains to be seen whether they ever raise a cumulative 100 basis points. The S&P500 is still well above 4,000, which is expensive. They cooled us off from insanely expensive to plain old expensive. Nothing wrong with that. This mini-bear is halfway to the bottom in terms of both valuation and time. Another 4 months of pain and another 10% drop isn’t going to kill anyone. This is how markets trade. Later in the year, the Fed will likely have finished its inflation fight.
Earnings are going up, but in real after-inflation terms, things have been getting worse for a while. The longer this continues, the worse it gets. The first chart goes up, but the REAL earnings chart has been falling, which indicates the pain everyone feels:
This is not good for the stock market – after 2 years of purchasing power declines, people are likely to dip into wealth by selling stocks and bonds. Of course, this is all offset by the massive increase in home prices, but that stimulative effect is mostly over, as markets across the US are cooling in April 2022.
What could possibly turn things around? How will things get better? Really the only potential catalysts for a big turnaround would be: (a) government stimulus: tax cuts or stimulus payments are unlikely – wait for them to be announced, that’s how to time it, (b) Fed easing: pretty good odds later in the year when the whole country wants it but the next few months are obviously tight. The fact that consensus is tight monetary conditions forever means that its likely to loosen up in 6 or 9 months, (c) lower energy prices: this one is toughest to call. Russia getting cut off from the world is a big negative for energy. Schlumberger and Halliburton have pulled out of Russia, and there is chatter that the Russians can’t drill on their own, which means that Russia would slowly lower output over time as wells deplete. For now, exploration is up, but not massively so. Oil companies print money at $85 per barrel, so they don’t necessarily need $105 oil.
Looking at the turnaround list, its hard to see anything that is likely in the near term. Nobody’s talking about it much, but the Shanghai lockdown is not good for anyone.
Locking down Shanghai doesn’t help the global supply chain either. Our contacts in Shanghai are unhappy with the lockdown, which is unusual, as they are normally quite supportive of government policies.
On April 18th, tech hedge fund Octahedron published this chart, which is disturbing on a number of levels:
First, does this chart look like its forming a base? Second, the inception of the index is 2015, which was many years into a massive bull market in tech growth names. Go back further, and this would look a lot different. Third, even in the healthy 2015 to 2018 period, the average valuation was probably 7.5x not 9.2 – that implies almost 20% valuation downside versus Octahedron’s expectations. Fourth, the index with the top names is still as much as 50% overvalued versus the 2015 to 2018 baseline. Fifth, many of those firms don't have earnings, so the revenue multiple has no bottom - implying that 9x revenues is cheap or "average" - Scary.
Thanks for reading: The Finance Professor