What Will it Take for the Market to Rebound?
The Best Companies Will Grow Earnings Power Even During a Recession
Cutting the oxygen from economic growth. If you’ve been even half paying attention, you know that stocks have lost huge amounts of money in 2022. You know that the problem is inflation, which is eating into consumer spending and confidence. The immediate origin of this problem was Covid-19. It sparked a series of overreactions, chief among them too much stimulus, which generated unrestrained demand. (Free money will do that.) Meanwhile, supply has been constrained, also due to ripple effects from Covid-19. Together, too many dollars chasing too few workers and not enough goods has produced a price spiral (inflation). The Fed first contributed to the creation of the problem, then compounded it with denial and by waiting too long, and has now turned 180 degrees and is now trying to “solve” its problem by closing the valves and choking off the flow of oxygen to the economy.
Labor and Housing are Next
Nearly every professional investor we know and economist we read is already convinced that a recession is inevitable or that we’re already in one. Higher interest rates will increase funding costs for companies and borrowing costs for consumers (notably in mortgages). Meanwhile lower stock market values create a reverse-wealth effect and inflation in necessities is hurting overall consumer spending. The impact on the consumer (whose spending is 2/3 of all U.S. economic activity) is already being felt, with consumer confidence falling to decade lows, even though we hear spending is mostly still going strong. Two areas that have yet to crack are the labor market, which continues to add jobs, and housing, with prices that appear to have been recently still rising. When home prices roll-over and the economy starts shedding jobs, the Fed’s course-correction will be complete and the conditions that created the inflationary spiral will have been destroyed.
But When Will the Market Bottom?
Questions are preventing investors from looking-through to the other side of the valley. Ultimately, we believe the market will rebound when investors sense that inflation is no longer a problem and that risks related to the Fed’s response to inflation have passed. In other words, stocks should start going up again when the outlook for interest rates stabilizes and investors start to anticipate positive economic growth resuming. Unfortunately, as we mentioned above, the conditions that gave rise to the inflationary spiral are still in place (too much demand and not enough workers or goods) and weaker labor and housing markets are probably required to break the cycle. This process has downside risks and will take an unknown amount of time to play out. In our view, the difficultly predicting the severity and duration of the coming downturn (which may have only just started) is the real foundation of current investor pessimism.
One factor we are watching is earnings expectations. Even though conditions are bearish, we also see reasons to be bullish. These include near universal pessimism and much lower stock prices. Both of these generally contribute to upward movements in prices. Another item we are watching closely is the direction of earnings revisions. On a very basic level, stocks trend to go up when companies beat earnings expectations and earnings grow, and stocks lose value when earnings come in below published estimates or decline. The below chart in Figure 1 plots the price of stocks (using the S&P500 as the green line) against aggregate expected future earnings per share (the red line). The divergence in 20222 tells us that investors are expecting lower earnings (due to the upcoming recession) but analysts (who are a lazy lot and wait for companies to tell them what to do) have yet to cut their forecasts. We expect that analysts will start more aggressively lowering estimates soon and anticipate that this will create horrible shocking headlines in the media. Some investors will probably sell on this news. However, we look forward to this as a positive. Significantly lower earnings expectations are often a precondition for stocks bottoming, in our experience.
Figure 1. S&P500 vs. expected next-twelve-month earnings per share.
Deep in the Metaverse but Still Catching Covid.
Last month I attended a technology conference here in Paris. I spent two days at Viva technology (https://vivatechnology.com/) Among my areas of focus was learning about the metaverse. I spoke with entrepreneurs with start-ups and also representatives from large technology and consumer brands. Just for the record, I have zero interest in ambling through a virtual world using a fantasy avatar version of myself. I certainly don’t anticipate spending any real money on imaginary real estate or holographic Nikes. I don’t even care if I’d be able to virtually dunk. All that said, I am more convinced than ever that the metaverse will be much more than the next gaming platform. I believe it will have applications across education, business (for meetings and training), medicine, and the military. There are also going to a lot of consumers that (for whatever incomprehensible reason) will want to transact and own digital assets in the metaverse. The bottom-line is that a lot of capital and effort is currently being deployed to create the infrastructure of the metaverse. This spending is currently much larger than economic activity or profit that is being generated, but this will change, and the inflection will become visible sooner rather than later, in our view. Unfortunately, in addition to picking up some ideas and good stickers for my computer, I also managed to catch Covid while at Viva tech. I have recovered (thanks for thinking of me) but I would have preferred the virtual version.
The Best Companies are Growing Earnings Power Even when the Market is Terrible
A recession is a natural event in the economic cycle and we’ve seen them before. Stocks shot up on the stimulus-infused flush post Covid. Now stocks are tanking as the Jerome Powell (the Federal Reserve Chairman, better known as The Economic Metronome) pulls back the stimulus. Keep in mind that most professional investors and financial professionals are focused on calendar year performance cycles, which contributes to short-term thinking and allocation of investments. The financial media’s incentive cycle is even shorter. Accordingly, both fund manager actions and the media content tend to be very thematic. For example, check out this article in today’s Wall Street Journal which provides several anecdotes of how consumers are changing their behavior in response to higher prices. The article backs up these not-so-randomly chosen interviews with colorful charts of consumer spending data. Unfortunately, the data is presented as the change since January, which is incredibly misleading as spending is seasonal and should always be interpreted on a year-over-year, rather than sequential basis. This oversight epitomizes the tendency of thematic bias in reporting, in our opinion.
How should you manage your investments for the second half of 2022?* This is the wrong question, in our opinion. Instead of thinking about the next six months, instead we are focused on which great companies we want to buy or own for the long-term. Wall Street has sent the stocks of many consumer, technology and cyclical companies down 50% or more. (The overall market’s 20% YTD decline is buoyed by the performance of energy companies that have risen thanks to higher oil prices.) Some of aforementioned consumer, technology or cyclical companies will grow revenues and earnings, even in a less favorable economic climate. Others will increase their “earnings power”, meaning they will grow their ability to produce higher revenues and profits, even if it is obscured current conditions. Just to reemphasize, there are many stocks trading at less than half their prices from a year ago whose long-term earnings and cash flow outlook is unchanged or even improving. Our ability to forecast macro remains highly limited. We also can’t control the near-term pricing of stocks. However, we believe we’ll do well if we stick with high-quality companies with advantaged business models and let management teams do the hard work of managing their operations during volatile times.
*Talk to your financial advisor about what is appropriate for your investment and risk profile.
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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