HUGE INSIGHTS: The Big Picture - Issue #10
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It's the Economy Stupid!
For all of Bill Clinton's faults, and there are many, he certainly got one thing right: "It's the economy stupid!" This was the clarion call of his 1992 Presidential campaign. A clear understanding of that fact got him elected.
Unfortunately, our present leadership has lost sight of this simple, yet crucial fact. Instead of building up the meritocracy that made this country great, the Biden administration, despite its success on the employment front, has pursued an aggressive social agenda focused on making sure everyone gets a trophy for participation. For good or for bad, it will likely cost his party the control of Congress -- ensuring that nothing gets accomplished over the next two years.
Meanwhile, economic growth has collapsed. 1Q real GDP growth was just revised down for the second time to -1.6%. That compares to a 7% annualized rate of growth in 4Q21. Regrettably, 2Q is looking even worse. According to the Atlanta Fed's GDPNow estimate, the economy appears poised to record another quarter of real GDP contraction to the tune of -2.1%. As a "rule of thumb," two consecutive quarters of shrinking economic output has coincided with every recession in the past 50 years.
Are We Already in Recession?
Politics aside, the answer to the above question affects us all. And the answer, in our opinion, is a definitive yes! We see a rolling recession currently underway, whereby certain pockets of the economy are benefitting from a shift in consumer behavior based upon pent-up demand, such as the travel and leisure segment, while other areas of the economy, such as retail and manufacturing are imploding. The long-term problem with this condition is that while the U.S. economy is 70% oriented toward domestic consumption, U.S. economic growth is still driven by its production.
Much of the problem with the decline in real GDP growth can be attributed to a spike in headline inflation. Who's to blame for that is more complicated. In one respect, the Biden administration, in its attempt to create a Utopian society, can be blamed for overshooting the mark on the fiscal policy front. In another respect, the Federal Reserve Board can be blamed for overshooting the mark on the monetary policy front. There is no doubt that the U.S. economy required every effort from policy makers to stimulate GDP growth during the depths of despair in 2Q20, nor is there any doubt that the adverse economic effects of the COVID pandemic were not equally distributed. But likewise, there is no excuse for the failure of policy makers to end and withdraw the economic stimulus once the economy had resumed its prior growth trajectory in 2Q21.
But there is a third party who is directly responsible for the sharp first quarter increase in the headline CPI data, and that's Vladimir Putin and his hardline communist regime. The invasion of Ukraine by Russia, it's implications for commodity prices, and the concomitant impact on supply chains was unforeseeable from the lens of monetary policy. In fact, this "black swan" event, which is out of the direct control of U.S. economic policy makers, has magnified the effects of the Fed's original policy error, forcing them to now slam on the brakes and overcompensate with a more aggressive shift toward monetary policy tightening than the economy has experienced in over forty years. The combined impact of raising the Fed funds rate over 300 bps by year-end, as implied by the June Dot-Plot, and the planned annualized balance sheet run-off of 13% (which some experts have equated to another 200 bps in annualized tightening) suggests that the Fed believes the real neutral funds rate resides somewhere in the neighborhood of 5%.
The economic implications of a rising rate cycle of this magnitude, from a baseline of zero, should not be underestimated. There is an old trader's maxim that goes like this: "The market climbs a wall of worry and slides down a slope of hope." The same is true of the economy -- quite literally. Historically, the first segment of the economy to roll-over is Housing. It shows up initially with a decline in NAHB confidence survey -- check. Then mortgage applications tank -- check! Finally, new permits fall off a cliff -- check!!
The second step is a fall-off in new Orders. This shows up initially in the U of Michigan consumer confidence survey (now at a record low) -- check. Then in the ISM data when new orders break below 49 -- check! And eventually, it shows up in consumer spending trends -- check (just ask TGT and WMT)!!
The third step of the process is just starting to unfold, so get ready for a big decline in Profits. The evidence has been building over the last six weeks, with lower manufacturing sales, capital goods spending, and industrial production -- check, check, check. Next, it is followed by lower forward guidance -- check (TGT, WMT, MSFT, CRM, INTC, MU, BBBY, KSS, RH, NKE, etc...)! Finally, as sure as night follows day, downward EPS revisions from Wall Street will follow!!
Last, but not least, Employment will roll-over. This is a lagging series and it won't register for a while. But when it does, you'll recognize the signs when you see them: lower average hours worked, lower non-farm payrolls, and lower personal income. In short, if its a lower CPI that you desire, then you must be prepared for and accept the price that must be paid in order to get it. The Fed most certainly has, and the administration has too; they've decided to sacrifice control of the House and the Senate, for a chance to retain the Presidency.
What's Next for the Markets?
In our opinion, the market has already discounted much of aforementioned rise in interest rates. This is evident by the contraction in the P/E multiple from 21x forward 12-month EPS estimates in January to around 16x FTM EPS estimates today.
The problem is that the EPS estimates have gone up over the last six months, not down. As stated in the previous section, we believe the process of lowering forward revenue and earnings guidance is just starting to unfold. As a result, analysts on Wall Street have not adjusted their EPS estimates to reflect the coming flood of 2Q earnings misses and lowered guidance yet. However, we have seen one change. Earnings revisions breath -- the difference between the number of estimates being raised and the number of estimates being cut -- has recently turned negative for the first time since peaking one-year ago.
That being said, according to FactSet Research, street consensus S&P op-EPS estimates for 2022 and 2023 have risen to $229 and $251, up 10% and 9.8% respectively. In our opinion, there is a VERY low probability that those estimates will come to fruition. Indeed, we have spent a good deal of time researching how revenues and margins have responded in the past to recessions and in particular, to inflation-based recessions. Using the 1969-1970 recession as our base case analog, we estimate that 2022 S&P op-EPS are more likely to decline by at least 5% this year, and then by another 3% next year. We are currently published at $198 for 2022, and $192 for 2023. Respectively, that's 16% and 31% below the street's consensus.
If our estimates prove correct, then the S&P 500 is currently trading closer to 19.5x FTM EPS, not the 16x that most of the bullish Wall Street market strategists assume. Of course, we could be wrong. But, if we are, our work suggests that its most likely our estimates are still to high. Importantly, P/E multiples have been known to compress into the low double-digits, if not high single-digits, during past rising rate cycles.
S&P 500: A Major Top Formation is Evident
The S&P 500 has already experienced a 24.5% peak-to-trough decline in 2022. How much lower does the market need to fall in order to adequately price in a recession? As mentioned above, the market has adjusted its valuation to account for the change in interest rates. Higher interest rates translate to lower P/E multiples for equities. But we still need to adjust for lower EPS. And that is yet to come. If our 2022 estimate of $198 proves correct, and we apply the current P/E multiple of 16x to that estimate, then we get a valuation that is just below 3200 for the S&P 500 index.
But from a technical perspective, we've identified a major top formation of the "Head & Shoulders" variety. This pattern is quite common, and has a very specific method for measuring a downside price target for the index. A measured move is determined by taking the distance from the peak of the "Head" to the "Neckline" and projecting it lower from the neckline at the right "Shoulder" to arrive at what is usually a fairly accurate target. In this case, that target is SPX 3500. This level coincides nicely with several other common support levels including the 200-week SMA, the 50% retracement of the advance off the March 2020 low, an open chart gap, and chart support at two prior weekly closing highs in August and November of 2020.
But we're concerned that this obvious level will not hold. As such we have been doing some scenario analysis in an effort to develop contingency plans. There are three such scenarios that we are currently entertaining: 1) The index hits our SPX 3500 target as discussed -- to this scenario, we ascribe a 40% probability; 2) The market cuts right through the SPX 3500 level and trades down to the Fibonacci 61.8% retracement level surrounding SPX 3200, to coincide with our expected valuation support -- and to this scenario we ascribe a 35% probability. In both cases we would regard these levels as an interim low that will be followed by a significant bear market rally, before another leg of the decline ensues in 2023.
But there is a third scenario that we are also considering, one that accelerates the cleansing process: 3) The market has already made its interim low on June 17th, and despite all of the negatives discussed above, to everyone's surprise, the market continues its nascent rally in fits and starts all Summer long to eventually challenge the June 2nd high around SPX 4200 to complete the aforementioned bear market rally -- and after sucking everyone back into equities, it subsequently collapses in an epic 2,000 point crash to re-test its March 2020 lows, halting its decline on November 8th, Election day -- and to this scenario, we ascribe a 25% probability.
Conclusion
If this all sounds a bit foreboding, keep in mind that there are ways to manage risk. One solution would be to consider buying some U.S. government Series I Savings Bonds. These are inflation-indexed bonds issued by the U.S. Treasury department that reset every six-months. They currently yield 9.62% through October 31st. Of course, there's a catch. You can only buy up to $10,000 per social security number, per calendar year. So, for example, if you're married, have one dependent child, and your wife is expecting to give birth to twins in this calendar year, then you could conceivably buy up to $100,000 worth Series I Savings Bonds over the next 12-months across all five social security numbers. But, keep in mind that you have to hold them for at least 5-years or you will be subject to early withdrawal penalties. Click link for more details below:
https://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds_ibuy.htm
Another solution would be to consider buying other short-term, high quality bonds. For example, the 1-year U.S. T-Bill currently yields just slightly less than a 10-year Treasury note at about 2.80%. This would be a safer, and higher yielding alternative to an FDIC insured savings account. It would also give you the flexibility to roll out to a longer maturity should interest rates continue to rise over the next year, or redeploy into equities in the late-Fall should the stock market crash as discussed in scenario 3 above.
Finally, we believe that there is a tremendous opportunity for skilled long/short hedge fund managers to produce outsized positive absolute returns in this environment. One such long/short trade that we have advocated for the last 6 months (long pure value/short pure growth) is up over 10% YTD. We continue to like the trade and see further upside potential for those who know what they're doing in the realm of absolute return investing.
On last thing, it pays to have a sense of humor during these times of woe. So, don't worry about the future, Chairman Powell is on the job. Trust him -- he's got this!
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