Share prices reached fresh 2022 lows at the end of last week. Rising prices for labor, goods and services (inflation) has become the number one concern of the Federal Reserve. The response is to raise interest rates. The Fed’s objective is to reduce the demand that is fueling inflation. This is a complete reversal from the approach initiated after the Covid-lockdowns, which was to cut interest rates and stimulate demand. The market sees this change and is convinced the result will be contraction in the economy (a recession) with lower corporate earnings. Investors are selling stocks now to get in front of this.
Is a recession preferable to out-of-control inflation? The Fed’s two stated objectives are to maximize employment at the highest level and to manage inflation at low levels. There is an inherent tension in these objectives. Too much demand for labor naturally generates higher wages. Companies respond to higher operating costs by raising prices for their customers including consumers. In 2021, stimulus checks, forced savings during Covid lockdowns and a rebounding economy along with other factors led to surge in consumer demand. Meanwhile, these factors and fear of Covid has kept some out of the labor pool, reducing the supply of workers. With demand high and supply of available workers low, employers are now racing to offer higher wages and benefits while simultaneously passing on the costs via higher prices. This is exactly what the Federal Reserve is supposed to avoid. Breaking this wage and price cycle requires reducing demand. We believe the Federal Reserve has already decided that a recession with more people out of work is preferable to runway inflation.
Could the Market be Wrong About the 2022 Rate-Hike Recession?
The market can only factor in what it can see. This may sound trivial, but it bears repeating that is that analysts and economists can’t see the future. Unanticipated events or changes in conditions can alter the course of what appears to be inevitable. A recession might be the most likely result of the Fed’s attempts to slow demand and cut off inflation, but things could certainly change.
Meanwhile, investors are also left guessing about “what’s priced in”. Last week’s drop in stock prices could be described as “free-fall” although we don’t think we’ve yet reached panic and despair selling. Investors may believe they should sell now to try to protect capital against the coming recession. However, in addition to the difficulty of forecasting the direction of the economy, there is a second challenge. How do we know when a bad future economy is already reflected in stock prices? When is it too late to sell? There is basically no way to know this, except in retrospect, which is exceptionally unhelpful. If we use history as an imperfect guide, it tells us that markets tend to bottom before or near the start of recessions.
The False Feedback Loop Provided by Prices
It’s natural to look to changes in stock prices to determine if “you were right” to buy or sell a stock. After all, if you invest in a company’s stock or even of you buy a cryptocurrency, and it goes up in value, then you were right to buy it, right? Similarly, selling a stock and watching it go down further afterwards means that you were smart to sell, doesn’t it? Two problems here. First, there is the challenge of time horizon. Investors are best served, in our opinion, if investment gains compound over the long-term with a minimum of taxable events. Using market action to grade your investment decisions risks focusing too much on the short-term, in our view. Second, when the market is under severe pressure, as it is now, stock prices get unhinged from fundamentals. Arguably the reverse situation was occurring during 2021 and previous years, when prices were rising quickly. In both ranging bull markets and during scary sell-offs, the price movements of stocks lose their ability to provide useful information about whether you should be buying or selling.
An unscientific review of recent market crashes bears out the view that stock prices can be very misleading about a company’s future. Simplistically, stock prices are determined by two factors, one, a company’s fundamentals (future cash flow and earnings) and secondly, how investors feel about the fundamentals. Isn’t there a relationship between these two things? Usually. But in extreme market environments, this relationship gets broken. To illustrate this point, we offer the below unscientific review of a small number of stocks, looking at how they fared during recessions and their subsequent earnings growth.
First, in Figure 1 we summarize the loss in value of a small number of popular, widely held names during the 2007-2009 financial crisis, the 2020 covid-lockdown panic and during the 2022 inflation spiral and rate pivot recession. During the 2007-2009 financial crisis, the group lost nearly half its value. During the 2020 Covid panic, nearly a third, and in the current inflation and recession scare, the group is down by more than a quarter from recent highs.
Were the stock price movements during the financial crisis and the Covid-panic good predictors of future earnings performance? Hardly. In the 10 years following the 2007-2009 crisis, Figure 2 shows that this group of companies increased earnings per share nearly 500%. Similarly, following the Covid-lockdown panics, several of these companies benefited from the pandemic with accelerating growth. The stock price movements did not correlate with each business’ ability to react to the situation. What about the 2022 inflation and rate recession? Third time’s a charm?
We recognize that analyst forecasts may be too high, but if we review the outlook for these companies to grow (Figure 2, right hand column) it appears at first glance like the prices are again detached from future earnings growth.
Conclusions & How We are Managing Investments* During the 2022 Inflation Spiral and Rate Recession
The market is trying to price in a recession. This makes sense to us, as the Federal Reserve is trying to stop inflation and the best way to do that is to destroy excessive economic demand. However, anything can happen, and a recession may or may not occur. Meanwhile, it’s extremely difficult to know whether stock prices already reflect more difficult future economic conditions. More likely, stocks will overshoot to the downside. Most of the time, stock prices reflect what professional investors think about a company’s fundamentals and share price movements will provide an indication whether things are getting better or worse. During periods of market excess or panic, however, share prices can get detached from a company’s prospects. Our approach, developed with experience and by making costly mistakes, is to stay invested, not to try to time the market or believe we can predict the economy. Instead, we look for companies with strong financial positions, top management teams and durable competitive advantages and to own these for the long term. Lastly, even though it is hard, we endeavor not to let stock prices tell us the value of a company.
*Talk to your financial advisor about what is appropriate for your investment and risk profile.
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John Zolidis
President & Founder
Quo Vadis Capital, Inc.
John.zolidis@quovadiscapital.com
Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017. He started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford. He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients. He also managed money in a buy-side role at a long-short equity fund over 2013-2014. He was named in the Wall Street Journal’s Best on the Street list in 2005. Mr. Zolidis and works from New York, NY and Paris, France or wherever he has his laptop.
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