Oct. 31, 2022
. . . in a world of bears.
Regular readers will know that Unhedged is not particularly bullish. The six-word summary: recession likely, not enough priced in. Most people, or rather most of the people we read and talk to, seem to be equally spooked (to use the seasonally appropriate term). Indeed, a question we have written about before and will have to do again before long is “if everyone is really so bearish, why isn’t the market lower?”
Remarkably, even last week’s big scary tech sell-off could not bring the October recovery to an end. The market is pretty smart most of the time. If it says stocks are worth X, or credit spreads should be Y, and we disagree, that makes us feel nervous, not clever. So we thought it might be good to construct the best case we could for taking risk here.
The bull case for risk
- Stocks are cheap(er): A very simple case for buying stocks is that you’ve looked up a chart of the S&P 500 and noticed that it’s down 18 per cent this year. That is sort of a dumb point to make! Assets that have fallen a lot can keep falling. Plus, large-cap valuations, while down a lot, still look a bit high compared to history. But not all stocks do. Take small caps. From January 2020 to the market top, the Russell 2000 rose as much as the S&P did, about 47 per cent, but has come down harder (24 per cent for the Russell vs 18 for the S&P):
This — and a general stretch of underperformance that reaches back five years or so — means that small and mid-cap valuations have gotten kicked into the dirt. Forward P/E ratios for the mid-cap S&P 400 (12.6) and small-cap S&P 600 (12) are at levels only seen in the depths of the pandemic and great financial crisis.
- Sentiment is still terrible: The very fact that it is hard for us to find any Wall Street pros who are outright bullish has to be a good sign for stocks. As Jeremy Grantham (bearish!) likes to say, the moment stocks start going up is not when the sun rises, but when the night goes from pitch black to just slightly less pitch black. And things are pretty dark now, with European war, China-US tensions, global inflation and a possible recession dominating the headlines. Below is the AAII sentiment survey. We think sentiment indicators may be a bit noisy right now. Note, for example, that outflows from stocks are not sending a similarly dreary message. Still, this is pretty bad (and therefore good):
- Volatility is not risk: Everyone we talk to — really, everyone — expects risk assets to be volatile in the coming months. But for investors with a longer horizon, who cares? All that matters is buying at prices that one will feel good about in, say, five years. There are a lot of investors who are required to care about volatility — anyone who reports monthly or quarterly returns to limited partners, basically — and that gives truly long-term investors a big advantage at moments like this.
- Investors are positioned very defensively: Staples, utilities, defence (not to be confused with defensives) and parts of healthcare have performed very well, as we have noted, and many of these carry unpleasantly high valuations. And investors are — according to the BofA fund manager survey — holding an unusual amount of cash and wildly underweight equities (three standard deviations from the historical mean). This will not always be true and, when it stops being true, risk assets will pop.
- Some individual stocks, especially tech/cyclicals, are starting to look washed out: Yes, we all hate tech now. But is Facebook worth a look at nine times earnings? Sure. The company, amazingly, still generates cash as fast as its CEO Mark Zuckerberg can burn it. And one totally cannot rule out the possibility that Zuck will get his act together. Intel is looking down the barrel of a chip glut, but at 15 times the $2 a share it earned before the recent boom, why not have a look? The point can be generalised: cyclical stocks (outside of energy) are much hated. This may not be the bottom, but there is a good case to start shopping now.
- The Fed might back off soon: Whispers of peak hawkishness are getting louder, egged on by doves at the Fed saying it’s time to plan how tightening ends. Many pundits expect a nod to this from Fed chair Jay Powell at the central bank’s press conference on Wednesday. Meanwhile, some central banks elsewhere are already starting to slow down. Australia’s did so weeks ago. Last week, the Bank of Canada raised rates 50 basis points, bucking expectations for a 75bp increase, while internal dissent is breaking out at the European Central Bank over the pace of rate hikes.
The yield curve offers a hint that rates might be about to peak. Last week, the 10-year/3-month spread inverted for the first time since the pandemic, now standing at -8bp. Historically, that is a sure-fire sign of recession (and we think this time is no different), but it also suggests markets expect rates to reach their zenith in the next few months.
- Evidence of disinflation is piling up: We’ve rattled off the list before, including prices for houses, goods, used cars, shipping services, commodities and much else besides. Last week added a few more items. Big tech’s earnings pointed to a sharp cyclical slowdown in digital ad spending. More broadly, third-quarter earnings are coming in below (already lowered) expectations; BofA counts a -1.3 per cent miss so far. On Friday, the employment cost index, a statistically robust wage indicator published quarterly, showed yearly wage growth slowing for the first time (one can quibble about this). Falling profits and slower wage growth should act as a drag on inflation.
How seriously do we take this argument? It has certainly gotten stronger in the past few months, if only because as time moves forward we are, by definition, getting closer to peak rates. But the story hinges on inflation coming down easy and a recession, if it comes, being small or “technical.”
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