Look around the poker table. If you can’t see the sucker, you’re it.
– Warren Buffett, February 29, 1988
The overall economic and market picture, which has been quite murky up to this point, is beginning to come more clearly into view. It has taken longer this time around, but it’s still the same old story. Although valuations in the equity market have come down some since last year, we anticipate more downside ahead as Q1 earnings start rolling in the middle of April.
Current Equity Valuations
On a pure price-earnings basis, the S&P is only moderately overpriced, currently trading at 22 times earnings (the median is around 15).1 Inflation-adjusted, however, the picture looks very different. Inflation-adjusted, equity valuations today rival the Dot-Com Crash and were even loftier than in the Great Crash of 1929.
(S&P 500 CAPE Ratio)
To put it plainly: if you had the chance to buy a pizza shop and were told that the inflation-adjusted profits were $100,000 per year, would you pay $3,000,000 for it? Would you buy something that took 30 years to get back, inflation-adjusted? Going back to the quote from Warren Buffett, there are apparently many people who are willing to do just that in today’s environment. We are perfectly content to sit out on the sidelines, and watch others gamble at the table. It won’t be exciting in the least, but that’s the way we want it!
When evaluating whether to buy or sell, inflation-adjusted is what counts and we can reasonably expect valuations to deteriorate further as interest rates continue to go higher and especially in regard to a recession.
Recession Probability
Speaking of recessions, the yield curve (10-year Treasury yield minus 2-year Treasury yield), which we believe to be the single best predictor of recessions, is screaming a recession. Historically, all 10 recessions since 1955 have been preceded by an inverted yield curve.2 The yield curve was so inverted this year, we would have to go back to the 1980s – 40 years ago – to find something similar. Could it be different this time? Yes it could, but we will gladly take the over and let more heroic types take the under on that bet. Rest assured, we won’t be betting on “this time it’s different” and will manage our clients’ funds accordingly.
SVB Crisis
(Silicon Valley Bank monthly stock chart)
On March 8th, 2023, Silicon Valley Bank was worth an $80 billion market cap. 48-hours later the market cap went to zero and the bank was in receivership by the FDIC. The stock traded as high as $750 at the beginning of 2022; it was trading at $0.80 on its most recent trading day. Banks borrow short from the discount window at the Federal Reserve and lend long to consumers. During the last few years, with ultra-low interest rates, SVB had invested in long-dated Treasuries for extra yield. They simply weren’t prepared for rates to be hiked 500 basis points in a year and then a bank run. A combination of these two factors led to it going under as quickly as it did.
Being the second-largest bank to fail in US history, the Federal Reserve stepped in to insure all depositors, including those over the $250,000 FDIC limit, in order to prevent contagion effects in the banking sector. The unprecedented measure seems to have worked for now, but it also shows how truly fragile the banking system is at the moment.
The inevitable consequence of bank failures is, however, restrictive lending standards and a significant tightening of credit flow. Even though it has been less than a month, we are already seeing evidence of this.3
Zombie companies will go under
About 13% of public companies are considered zombies, meaning they don’t earn a profit for shareholders. These companies hold at least $1 trillion (yes – trillion with a ’T’) worth of debt.4 Forget about being profitable, some of these companies don’t even have any revenue. Given the 5-fold increase in the cost of capital over the last year along with more restrictive lending standards, we expect perhaps hundreds of these zombie companies to declare bankruptcy within the next year or so. The non-profitable tech index is back to where it was a couple of years ago and we expect it to fall further from here.
Why is the stock market up then?
Bear markets are famous for fantastic rallies, oftentimes termed a bear-market rally, in excess of 20%. The Nasdaq is apparently in a new bull market right now, rallying over 20% from its October lows. But thankfully for us, traders and investors have very short memories. The Dot-Com Crash had eight 20%+ rallies in the Nasdaq; each one eventually rolled over and made new lows. Just a reminder, during the Dot-Com Crash the Nasdaq ultimately fell 84%, peak-to-trough.5
Now of course, we have to ask the question: what if we’re wrong? If our market thesis is wrong, we may miss out on a net of 10-15% on the upside, compared to our existing investment strategy. On the other hand, if we are right, we will have saved our clients at least 20-40% on the downside. We will take those odds any day. At the moment, most of you are positioned extremely conservatively with lots of liquidity to take advantage once the storm has passed and the dust has settled.
Some of our clients have asked: Is it going to be mild or severe recession? The answer is, it doesn’t matter. As bond manager Jeffrey Gundlach said recently, you’ll need an umbrella in either case.6 One of the mildest recessions we ever had was during the Dot-Com Crash; the S&P still fell 50%.
Many economic indicators are signaling recession. If we don’t get one, it will be the first time in US history that this set of indicators has been wrong. As we have said before, we’ll take those odds. In the meantime, we are expecting earnings to be revised downwards over the next couple of quarters, after which, we intend to move our clients into greater equity exposures.
Sources:
1S&P 500 PE Ratio. (2023, April 6). Multpl. https://www.multpl.com/s-p-500-pe-ratio
2Ward, S., & McVearry, R. (2023, February 22). Inverted Yield Curve: Is It Still a Recession Indicator? US News & World Report. https://money.usnews.com/investing/articles/inverted-yield-curve-is-it-still-a-recession-indicator
3Brown, C. (2023, April 4). Lending conditions, term loans tighten “sharply”: Dallas Fed survey. Axios. https://www.axios.com/2023/04/04/lending-conditions-term-loans-tighten-sharply-survey
4Daniel, W. (2022, October 1). A huge number of ‘Zombie’ companies are drowning in debt. This CEO sees a reckoning as interest rates soar. Fortune. https://finance.yahoo.com/news/huge-number-zombie-companies-drowning-120000776.html
5Authers, J. (2022, May 17). Bear Market Rallies Can Be a Treacherous Lure. Bloomberg.com. https://www.bloomberg.com/opinion/articles/2022-05-17/bear-market-rallies-are-dangerous-as-dotcom-crash-gfc-show?leadSource=uverify%20wall
6Bond king Jeffrey Gundlach: Here comes the hard economic landing. (2023, February 22). Yahoo Finance. https://finance.yahoo.com/news/jeffrey-gundlach-here-comes-the-hard-economic-landing-200336646.html
Investment advisory services offered through ConCap® LLC, a registered investment advisor.
The opinions expressed in this commentary are those of the author. Any contents provided are meant for informational purposes only, does not constitute tax or investment advice, and should not be regarded as a recommendation, an offer to sell, or a solicitation of an offer to buy any security or interest in any fund or issuer of securities. They are also not research reports and are not intended to serve as the basis for any investment decision. Comments concerning the past performance of [e.g. monetary instruments, investment indexes or international markets] are not intended to be forward looking and should not be viewed as an indication of future results. All investments involve risk, and the past performance of a security or financial product does not guarantee future results or returns.
