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Observations by David Robertson, 10/28/22
It was another busy week with central bank news, company earnings reports and of course, mid-term election developments. If you have questions or just want to get some perspective on the whirlwind of happenings, let me know at firstname.lastname@example.org.
Arguably the most market-moving news of the week was talk of the possibility of Treasury buybacks being made. This policy idea was floated earlier (I discussed it in August) but has been rapidly gaining traction especially in light of the gilt crisis in the UK. In short, the idea is that some Treasuries could be bought in order to establish greater liquidity without interrupting the broader quantitative tightening project.
That’s all well and good but the signal was taken that the Fed is going to come in and save the day again and it’s off to the races for stocks.
Stocks were also bouyed by a weakening US dollar. The slide in the dollar was related partly to the prospect of a slowing trajectory of rate increases and partly to a stronger Chinese yuan. The stronger yuan was clearly the result of intervention so it is hard to consider that move as anything more than passing.
Mr. Blonde’s view on the earnings cycle is unchanged from very early this year (here). Growth deceleration and negative revisions this year that turn into negative growth rates in early 2023. Nothing from recent reporting seasons suggest that view is not on track. Before its all over, S&P 500 EPS will be closer to $200 or less from its current $220 and compared to 2023 expectations of $237 (down from $252 earlier this year).
In general, I think this is a pretty good characterization of what to expect from earnings. Overly optimistic expectations earlier in the year should (eventually) give way to the ongoing headwinds of higher input costs (not least of which is labor) and higher financing costs. These things take time to cycle through but that doesn’t mean they aren’t real. Starting from a position of record high margins also creates risk since there is a lot of downside.
None of this suggests there will be an earnings catastrophe, but lower earnings do not appear to be discounted in stock prices yet. This certainly appeared to be the case this week as many of the big tech companies reported earnings.
Alphabet, Microsoft, and Facebook all reported and all disappointed on revenues. Facebook also disappointed materially on earnings. On Thursday, Amazon reported terrible results and guidance and Apple just reported moderately disappointing results and vague guidance. Each of the stocks got beat up after its report though Apple fared better than the others.
A graph from themarketear.com ($) below shows these results are representative of a broader theme this quarter: If you miss, you get hit.
A final comment is that weakness in ad revenues featured prominently in these reports. While ad revenue is cyclical and is normally one of the first expenses to get cut when business turns down, digital advertising has also benefited from a huge tailwind of demand from tech startups.
In an age of cheap capital, investors were willing to take bets on just about any story that sounded remotely plausible. Those startups worked quickly to build revenues and gain scale - and did so partly by buying a lot of digital ads. Now, with capital for new tech startups substantially diminished, an important source of demand for advertising is curtailed. This isn’t over. A lot of cheap capital got converted into short-term growth.
Nice thread by @hkuppy here highlighting what is sure to become one of the more important features of this downturn - the deferred recognition of losses by private equity (PE) firms. When investments are private, PE firms are allowed a great deal of discretion regarding how those investments are valued on an interim basis.
This leads to a number of phenomena that are far more about appearances than reality. For one, since private investments are valued less frequently, they “appear” to be less volatile. Similarly, when public investments take a dive and the marks on private investments don’t, it is the public ones that appear more volatile - even though - and because - they are far more liquid.
This allows PE firms to defer the recognition of losses on private investments - and that allows them to live to fight another day. It also shields them from the intense scrutiny of public companies - whether that be in regard to poor performance - or outright shenanigans.
When downturns are short, the relative lack of transparency of private equity is a feature since it prevents undue focus on transient weakness. When downturns are a function of a broader-based regime change, as the current one is, private equity’s lack of transparency serves to prolong the downturn by hiding business weakness and credit problems. Expect to be hearing about private equity portfolio companies being in trouble for a long time.
With the culmination of China’s Party Congress, most of the news focused on the visibly dramatic ouster of former President Hu Jintao and on the refreshed membership of the Politburo Standing Committee. While these insights have their place in assessing the investment landscape in China, the following comments from @Brad_Setser and @michaelxpettis quite arguably provide everything you need to know.
For one, the quality of economic data in China has been deteriorating at a rapid rate. While China never ranked as a stellar provider of economic data, for a time it provided enough information to be able to connect the dots. Now, it’s hard to confirm much of anything.
Further, Michael Pettis makes an excellent point that an analysis of Chinese growth can be simplified by focusing solely on domestic demand since that is the real indicator of economic health.
The bottom line is there is an extremely narrow path by which to restructure China’s economy and there are extremely limited policy options. It just doesn’t matter that much who is doing it or what they call it.
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Investment analysis I
The number one question I get from new traders is: “Where do you get your trade ideas?” and it’s not a simple question to answer. First of all, I would say that if you work to become an expert in your particular market, you will find more and more that the good trade ideas come to you. They appear organically out of the hard work and research you put in.
Much of good trading is just making yourself available to the market and waiting for good ideas to materialize. The best traders don’t ‘scour for ideas’ – they pay attention to the constant flow of information on their screens and act only when something seems dislocated or poorly recognized. It’s an attentiveness game that relies on endurance – not a chart-scrolling game that relies on volume. In other words, trading is mostly a passive process. It is mostly not about trading. It’s about remaining patient while actively digesting information, not actively looking for trades.
I really enjoyed this Substack piece by Brent Donnelly partly because it reveals so many parallels with my approach to investment analysis, whether that be in regard to stocks or exposures to other financial assets, and partly because it highlights some common misunderstandings about the idea generation process.
First off, I completely agree with Donnelly’s comment that idea generation is “an attentiveness game that relies on endurance”. It can be hard to describe to novices, but as with any endeavor, the more you know about it and the more experience you gain, the more you can “see” patterns and the trajectories of interrelationships. Interestingly too, this often happens because of the fact that you can see how commonly used models misinterpret unusual situations.
This raises another important point. Many people argue it is impossible to have an edge in trading or investing and as a result superior performance is merely a matter of luck rather than skill. This type of skepticism is understandable for people who have never rigorously developed the skillsets or experience to be top performers.
It is common for such people to rely instead on process to drive their investment activity. To be sure, process is important in many respects - for risk management, monitoring investments, operations, compliance, and for the development of useful tools, among others. At the end of the day, though, process is merely the ante for decent investment performance (and error minimization), not the key to excellent performance.
Finally, and this is another key point, investing and/or trading is not a 9-5 job. It just isn’t. It requires constant research, observation, and reflection. As a result, a person’s disposition in terms of curiosity, grit, drive, and resilience are all critical factors - in addition to intellectual capacity. While there are plenty of people outside the investment industry who have these characteristics, the full-time attentiveness and endurance are material constraints for most people.
Investment analysis II
I don’t know that it [the value style] ever comes back. Most of the value investors have been put out of business. It used to be we could buy something at a reasonably low multiple, whatever we thought it was, see the company do somewhat better, benefit from it doing somewhat better, and realize that other investors would see what we saw six months later or a year later and would re-rate the shares so you’d buy something for 10 times earnings... you’d get another 3 points on the multiple and you would make 50% after three years. That isn’t happening any more because there’s nobody to notice what actually happened to these companies... Nobody knows what anything is worth.
This quote by David Einhorn (and reported by John Authers ($)) certainly captures the travails of us value investors. It hasn’t been easy and many have gone out of business.
That said, I believe Einhorn’s analysis is too pessimistic. First, value investors don’t need markets to reprice stocks to higher multiples to succeed - they only need to be right that cash flows will improve. In fact, Warren Buffett has expressed preference for this kind of outcome because that way he can keep adding shares of excellent companies for attractive prices. Growing free cash flow is the gift that keeps giving.
In addition, the fact that “nobody notices what actually happens to companies” is the very definition of an inefficient market and one in which a good value investor should excel. I suspect Einhorn’s main complaint is that it is hard to run a big hedge fund under these conditions and that is probably true. But this is starting to get very interesting for relatively small, valuation-oriented, long-term investors.
THE END GAME EP 38 – JAMES AITKEN ($)
He [Rob Kapito, Blackrock] said, “Look, over the decades past, you needed to have a big allocation to alternatives, growth stocks, illiquid and everything else if you’re going to hit this magical and somewhat mythical 7.5% nominal return target … Look, with yields up and spreads wider, you don’t need all the risky stuff. You don’t need it.”
I mean, we could look at derivative positions that people post. We can look at central clearing, we could look at all of that. And to be very clear, the system’s working okay here. People aren’t liking all the prices they’re getting or seeing, but the system’s working okay. It’s just getting progressively more difficult for people to lay off or unwind the risk that they feel compelled to unwind or lay off. And I think we’ve got a long way to go.
This was a wide-ranging, timely, and insightful analysis of some of the most important happenings in the markets right now.
The first quote addresses the regime change to higher inflation and higher interest rates. The implication is straightforward for long-term investors like pension funds. With decent returns emerging from fixed income, there is just no need to take nearly as much risk with other parts of the portfolio. This is every bit as true for long-term individual investors.
As Aitken lays out, this means “slow moving capital [like pension funds] is going to be an ongoing organic seller of all sorts of risk assets for a long time to come”. This will create a persistent threat of selling pressure. As he summarizes, “It’s a different regime, it’s going to be tricky.”
The second quote addresses market structure and “plumbing”. According to Aitken, forced sellers sometimes need to suck it up and accept a low price, but in general, “the system’s working okay.” This is good news in terms of not having to worry about a sudden market meltdown, but bad news if investors are looking for the Fed to bail them out again.
A number of stories came out at the end of last week regarding the future trajectory of the Fed’s monetary policy. While it is only logical the Fed cannot (and should not!) raise rates indefinitely, @biancoresearch is absolutely right that any discussion of easing up on monetary policy sends an important signal:
This creates an enormous challenge for the Fed. Regardless of the fact that policy needs to taper down to neutral at some point and regardless of the possibility it could stay there a long time, investors still see such an inflection as a meaningfully positive one. As the following tweet illustrates, speculative fervor is as strong as ever:
This all makes the job of the Fed that much harder. On one hand, it does need to ramp down rate increases at some point, assuming inflation doesn’t continue rocketing higher (it should not). It also needs to ensure financial stability by ensuring adequate liquidity for Treasuries which often becomes a bigger issue at year-end.
On the other hand, anything it does to incrementally loosen policy, or even to signal such, will be perceived by markets as bullish. As such, it will serve to undermine the fight against inflation. It will also serve to undermine the Fed’s credibility and therefore ability to contend with inflation in the future. Not an enviable position.
Implications for investment strategy
It is not lost on me that after posting a market review for the third quarter last week which highlighted the phenomenon of government takeover of money creation (and therefore the expectation for a new regime of higher inflation), that I still spend a lot of time and effort watching the Fed and trying to interpret its moves.
The reason for this is while I believe the destination (higher inflation) is fairly clear at this point, the journey there is not. Not only is the path forward TBD, but with low liquidity, considerable speculative interest, and multiple pressures on the Fed in both directions, market swings can be wild. Further, geopolitical conditions and other extraordinary events can easily lead to path dependence. The bottom line is there is a lot of variability in possible outcomes and it is really important to monitor the situation actively.
In regard to investment actions for long-term investors, this mainly means remaining defensive. Stock valuations are still not very attractive though short-term Treasury rates are becoming more palatable. The advice for long-term individual investors is the same as that for long-term institutional investors: “you don’t need all the risky stuff. You don’t need it.”
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