Blueberries, Blowups and Babies

This article has been excerpted and edited from our quarterly newsletter to clients dated February 15, 2022.

No, we did not run out of titles. With a complex set of issues overhanging the markets, we felt a somewhat puzzling title was fitting. Market participants appear confused, with polarized views as to whether the investment outlook is promising or ominous.

The wicked combination of surging demand and supply constraints has created imbalances causing unwanted inflation. Though a minor and anecdotal example, blueberries have risen in price and, worse, been absent altogether on several occasions from our local grocery store shelves.

Despite the dramatic rise in the inflation rate, the stock market has blown up, in a good way, rising to new all-time highs—in bubble-like fashion in certain sectors, reminiscent of the dot-com period—the lift in the markets since the pandemic lows driven by economic expansion and the strong earnings recovery. More recently, fearing excessive prolonged inflation, central banks around the world have begun to tighten monetary policies. In reaction, mostly to rising interest rates, many stocks have blown up, not in a good way—some declining materially from recent highs after reporting results that were poor or that simply didn’t meet overly optimistic expectations.

During the last economic cycle, from the Great Recession of ’08/09 to 2020, developed countries around the world grew at a below-average pace. Poor demographics are partly to blame, inhibiting population growth. Too few babies have been born in the last number of years. Last year, the U.S. suffered the lowest population growth rate since 1776 (meaning ever). This does not bode well for the overall growth outlook.

Good, Bad, or Otherwise

A bit of inflation is good. Deflation is certainly less desirable. So monetary authorities, in response to the pandemic, pushed all their available levers to spur growth and reignite inflation. But now we’re left with a bit too much of a good thing.

Our pocketbooks will be impacted by higher prices for goods and services. Consumers may have to cut back on their blueberries, despite the fact that they’re extremely good for you. Though, just like broccoli and brussels sprouts, some people don’t care about what’s good for you. Perhaps they’re the same ones who’ve ignored the risks associated with overvalued or speculative (meme) stocks.

Blowups in the market can be good too. To profit on the upside and, though it doesn’t feel that way when it’s happening, normalization, on the downside—a cleansing which provides better investment opportunities. We don’t view the recent correction as the herd panicking. It appears to be normal course selling—profit taking—reactions to full valuations, or to ones that were extreme, and a pricing-in of higher interest rates and the likelihood of slower economic growth.

Our job, as asset managers, is to distinguish the wheat from the chaff, the signal from the noise, the baby from the bathwater. Babies are definitely good for you. Baths too. Bathwater, perhaps, not so much. And, in overall market corrections, when selling often becomes indiscriminate, especially near bottoms, the market tends to discard even high-quality stocks—throwing those beautiful babies out with the bathwater. We stand ready to catch them.

Market participants have been selling before gains go down the drain. Our recent mantra has been “Sell the rallies” not “Buy the dips” because we’ve been expecting much more than a dip. That’s not to say that we’ve been expecting a recessionary-based bear market—prolonged and pronounced negative returns while underlying values are falling. We’ve been anticipating a correction, albeit maybe a substantial one, since prices started falling from levels that were above our estimate of fair market value (FMV). With intrinsic values rising, it should ultimately provide confidence and temper declines because prices should only drop so far while underlying fundamentals are strong and values are increasing, catching up to prices.

Deceleration

An alternate title for this letter could have been “Disruptions, Debt and Demographics.” It’s been the interplay of supply-chain bottlenecks during a demand spike, spurred by burgeoning debt, which has ignited inflation. And these same factors, along with prevailing demographics, should be at the root of the slower growth and disinflation that we expect in the months and years ahead.

Prices have lifted for cars (used ones too), houses, food, gasoline (led by oil), and just about anything commodity related. Core PCE, the broadest inflation measure, grew by a hefty 4.9% for December. Though, excluding Covid-sensitive items, it was a more restrained 2.4%. Both, much lower than the recent CPI figures above 7%. Thankfully, we are starting to see a leveling off in commodity prices. And in this area, high prices always bring about higher production which in turn lowers prices—a self-correcting mechanism.

Inflation has spiked, along with economic growth, because demand surged just after supply was dormant. Price rises were further heightened because of shortages relating to limited manufacturing capacity, clogged ports, flooding, droughts, and a shrinking labour pool. Some have left the workforce and, with unemployment so low in the U.S., there are 2 million more available positions than those searching for employment—search consultants are burning out.

Consumer spending should remain strong. Consumer balance sheets are healthy, the labour market is tight and wages are rising briskly. As the economy reopens, service-related spending should see a surge. The rate of economic growth should slow though from its unsustainable pace, but growth should nonetheless continue. As consumers and businesses alike become more comfortable with reopening, we expect a material shift of demand from goods to services. This should keep the economy buoyant—though a demand surge on the services side could keep inflation high in the near term which would force central banks to tighten aggressively.

The overindebtedness of most developed countries does not auger well for economic growth rates. Debt this high normally acts to suppress growth. Pre-pandemic government debts were already too high and then they piled it on. The negative real yields (bond yields less the rate of inflation), which are extremely rare, should also be a concern. Rarely are negative yields seen during an economic expansion.

It won’t help interest rates that central banks will be purchasing fewer bonds and deficit spending will require continuous substantial government bond sales. Higher yields may be needed to attract purchasers but higher interest rates also act to restrain growth.

The debt and demographics (less population growth and more retirees which increase savings rates and lower consumer spending) are also growth inhibitors, not to mention that the pace of growth is projected to slow merely because the comparisons with previous quarters will become difficult. The decline in money supply should dampen growth. And, when growth rates subside, so too should inflation.

Reversion

As interest rates rise and economic growth decelerates, valuations should compress, reverting from stretched levels. Even at its highs, the price-to-earnings multiple of the S&P 500 had declined from the beginning of last year because earnings growth outpaced the price increase of the index.

The correction we feared has commenced. Just as the herd mentality pushed stock prices too high, we expect an overshoot on the downside too. Despite the recent declines, the markets are not near typical investor capitulation readings. Volatility levels are typically higher near bottoms as well.

Stocks trading too high because of speculation have been hit particularly hard. Netflix, Tesla, Nvidia, eBay, Salesforce.com, PayPal, Twitter, Spotify, Meta Platforms (formerly Facebook), and PayPal have all fallen by at least 30% (some by more than 50%) from their highs.

That still leaves the tech index only halfway down toward a TRAC^TM floor, while the S&P 500 remains toppy, still at a ceiling in our work.

Taming broad-based inflation isn’t easy without the central banks excessively hitting the brakes. If we are not correct about inflation subsiding, then market valuations will have much further to fall because interest rates, a key factor in determining valuations, would rise materially.

OUR STRATEGY

In early January, short interest (percentage of stocks sold short) hit a new low—a sign that markets were too lopsided. For this reason, despite no negative signals from our Economic Composite or our Momentum Indicators (both designed to alert us to prolonged market downturns), we have left our hedge (short the U.S. stock market via ETFs in Growth accounts or inverse ETF holdings in registered or long-only accounts) in place. Valuations this high are a rarity, and we’ve been expecting a reversion. We did recently cover a portion of our hedges after the markets declined and look to cover the balance once the markets are more reasonably priced and close to floors.

In a bear market, the average S&P 500 decline is about 36%. Corrections, in non-recessionary periods, average around 15%. Since prices rose too far above underlying values, and interest rates are rising in response to inflation, the current correction could be above average. Any tempering in growth won’t be welcome either as it has direct implications for corporate earnings.

We are wary of stocks overly reliant on economic growth. Commodity stocks could suffer along with other cyclicals if growth rates abate. However, we hold positions, and are looking for others, whose earnings are expected to rise yet trade at substantial discounts to our FMV estimates. And, as the markets correct, we believe security and sector selection will be even more important to protect against overall market downdrafts.

Gotta See the Baby

Though it’s normally “buy low sell high,” our recent playbook has read “sell high buy low.” We do, however, believe the normal playbook will soon be in use.

We look for new investment opportunities where securities have already suffered, often discarded because entire sectors are out of favour. We’re searching for the baby. As Seinfeld said, “Gotta See the Baby.”

Prices have been unusually high. From a top-down perspective, we have been concerned that a correction was overdue. And from our bottom-up analysis, we have found little in the last several months that warrants a new investment.

That has not stopped us from seeking out companies that have competitive advantages, a good growth outlook, and solid financials—waiting to pounce on opportunities when prices are sufficiently below our estimates of fair values. Our list of candidates is long—we’re pregnant with ideas—and can’t wait to see the babies.