Combined, we – Paul or “dad” to me, and I - have written well into the 100’s of newsletters. Yet this newsletter will be the first one that either of has written in which there is no track record of performance, or a fully transparent portfolio attached to the words. This is the natural evolution of switching to a family office in which we manage solely our own money. However, this relationship can create the illusion that the purpose of these newsletters is to make “smart sounding” predictions. Which is far different from making money, beating investment indexes, protecting capital, and providing value to you, the reader. To cement this distinction let’s examine two statements:
Statement 1: “Peloton will sell tons of amazing home exercise bikes, users will be loyal, and they will innovate into new products!”
Statement 2: “Peloton will sell tons of amazing home exercise bikes, users will be loyal, and they will innovate into new products! However, investors are expecting more growth than is reasonable, demand was pulled forward due the pandemic, and margins are unsustainable.”
Both statements can be true. However, as an analyst or market commentator whose goal is to be “correct,” why add the second sentence? After all, statement 1 was correct in 2022, yet the stock fell nearly 80%! Often the smartest sounding investors can have the worst performance records. A part of this can be attributed to emotions – lack of patience, discipline, and conviction – but good investment outcomes only partially stem from being correct. They also require an understanding of what the market is predicting for a company, sector, or index.
Today, headlines and predictions of a recession in 2023 can be found in all corners of the financial news. In a Bloomberg survey of economists, 70% expect us to enter a recession at some point in the next year. The highest percentage in the history of the poll. Many are calling the incoming recession “the most anticipated recession ever.” Interestingly, however, stock market valuations paint a different picture. Broad U.S. stock market index valuations are still abnormally expensive and credit spreads are tight – occurrences you would find during a period of economic prosperity, stable margins, and low interest rates. Not the sort of valuations you would see on the precipice of a recession and the ensuing decline in company earnings.
So, what gives? Why the optimistic valuations but pessimistic backdrop?
The most likely answer is that investors are looking past this upcoming recession and participants are investing now for the future recovery and stimulus - rate cuts and lower interest rates - from the Federal Reserve. The consensus schedule looks something like:
First half of 2023: Recessions in Europe and U.S. Economies that brings down inflation.
Second half of 2023: Central Banks cut interest rates and capital is cheap/free once again.
Beginning of 2024: Economies recover, and businesses thrive.
Arguably, this consensus forecast is the best-case scenario for investors. Without a recession, it seems very unlikely that inflation will fall back to levels at which an economy can function properly – around 2% to 3%. So, like a band aid, the hope is that we can “rip it off,” get the economic pain over quickly and move on to more normal times. Supporting this story line are the numerous signs of stress seen in recent economic data. Spending is slowing, defaults on auto-payments are now higher than during the great financial crisis, and with each week, a new company is announcing mass layoffs. The poor data, while concerning to some, has generally been received with excitement from stock market participants. The tech heavy NASDAQ index is already up over 11% in 2023, “meme” stocks are once again acting irrational, and bitcoin is off to its best January in history! This “risk on” behavior is likely all predicated on the belief that the poor economic data we are seeing now will lead to rate cuts later this year. An occurrence – rate cuts – that is thought to bring about higher share prices on the back of lower interest rates.
We’re not so sure.
Since 1900, there have been three times in which stock market valuations were as high as we have seen in recent years. Each occurrence ended with a recession, which as you may have guessed, was accompanied by rate cuts. However, the dates didn’t coincide very nicely with the commonly held belief propelling markets forward today:
- In December of 1929, the federal reserve began cutting interest rates. Two and a half years later the market bottomed, falling 79% after the first cut.
- In December of 2000, the federal reserve began cutting interest rates. Two years later the market bottomed out, falling 41% after the first cut.
- In September of 2007, the federal reserve began cutting interest rates. One and a half years later the market bottomed, falling 55% after the first cut.
You could argue these recessions, and time periods are cherry picked. After all, they are cherry picked to show other times periods with “bubble” type valuations. Yet, the main takeaway from these examples is not so much that the market and economy will crash in the coming months, but rather that it could. As investors, our role is to examine and weigh the possible paths forward in markets, not choose the most likely one and invest accordingly. Today, the path forward is marred with significant dispersions in outcomes. The range of outcomes, furthermore, is skewed to the downside. The economy is weakening, companies have been blessed with high profit margins that will need to fall, a land war still rages on in Europe, millions of jobs sit vacant with no one to take them, and inflation – while softening – is still near 40-year highs. And as we’ve shown, even the best path forward in the market is no guarantee of positive returns. Underpinning all of this is high valuations that will be an anchor for shares to rise, and fuel for them to fall.
By no means are we suggesting sitting in cash with fear – we’re not (!) - but rather to invest prudently in sound companies trading at lower valuations – which can be found in small cap indexes and international markets – and be a little more conservative in your asset allocation. Most importantly, now is not a time to take on margin or to borrow for investment purposes.
A great and wonderful 2023 to all. And the sincerest thank you for all of the support these last few years.
- Keeston Sutherland, CFA, CFP
Paul’s note:
Paul will not be writing a piece this quarter. Rather he is currently on a boat heading to Namibia! However, rest assured, he might be back in time to make his long awaited appearance on next quarters newsletter.
With the closing of Sutherland Integrated, the business phone number has been turned off. Please, feel free to reach out to me anytime on my personal cell phone: 808-359-4727 or at keeston@sutherlandintegrated.com.