The Long and Short of It

This article has been excerpted and edited from our quarterly newsletter to clients dated May 19, 2023.

What generally follows that expression is a succinct synopsis. We’re always trying to be concise; however, distilling complex economic and investment matters usually requires several pages. Case and point, explaining why we are simultaneously long and short will take more than a few paragraphs to properly convey our rationale.

We own stocks (long positions) principally because stock markets rise over time. Populations grow, unit volumes rise, revenues increase, profits expand, underlying valuations track higher—up and to the right—and stock prices follow suit. We look to participate in the upward bias of long-term market trends, selecting individual securities we believe to be higher quality and more undervalued than the averages.

In the short term, market prices can fluctuate considerably from price volatility fueled by market psychology. This is generally driven by market participants reacting to specific events or when recessions occur which periodically interrupt the upward trajectory. Therefore, we short from time to time, particularly when we expect a recession, to hedge against expected declines—to mitigate losses we may incur on our long positions during market downturns.

Because we don’t have a crystal ball, even when our models are suggesting a market setback, we still don’t wish to eliminate our longs since the upward bias of the market is a powerful force—markets rise most of the time, and by healthy compounding amounts. It’s also much simpler to invest from a bottom-up standpoint since there are fewer moving parts to individual companies whereas a top-down stance is subject to all sorts of external influences.

Though, if we foresee a downturn, as we do now, we may raise additional cash and alter the nature of our long positions for additional protection.

Our favourite investment period was during the year 2000 when the dot-com bubble burst, and the market rotated to previously ignored stocks. As market prices normalized, our longs went up and our shorts went down. Perhaps it’s wishful thinking that this best-of-both-worlds scenario could repeat; though, we see similarities in the makeup of today’s market.

Because we expect a U.S. recession to begin soon, we are short the S&P 500, which remains fully valued, lifted up by a handful of behemoth companies. And, we remain long high-quality, recession-resistant companies, whose share prices are at compelling discounts to our estimated fair market values (FMVs). Since we aren’t certain of the timing of market declines or our stock holdings rising to close disconnections with value, we emphasize our long positions and hold a smaller short position as a hedge (a one-page explanation—not bad).                                  

The Recession is Coming (Shortly)

Our Economic Composite (TEC^TM), which has historically forewarned of a recession (without a false signal), on average 10 months prior to the peak in the business cycle, triggered a negative signal for the U.S. last October. Based on the historical average, we could be a mere 3 months away from the recession onset. And the U.S. is not alone. We’re concerned about many nations because negative signals have also occurred for Canada, Germany, and the U.K.

The primary driver of TEC^TM is the inversion of the yield curve, more specifically when the 90-day T-bill rate exceeds the 10-year bond. Generally, this inversion, from central banks raising short-term administered rates, causes economic deterioration to begin after about 6 months. The inversion during this cycle is historically extreme—as considerable as it was in 1929, 1973, and 1980—periods when harsh recessions ensued.

The rise in interest rates has been felt across the U.S. economy. Commercial and Industrial loan growth is declining, for the first time since 2020. And it began declining before the recent U.S. bank failures, which were 3 of the 4 largest of its kind. Lending standards have become stricter. And bank deposits have been fleeing to money-market funds where rates are much more attractive. This inhibits lending because loan-to-deposit ratios must be maintained. At the same time, corporations are also less willing to borrow because of economic uncertainty and higher costs (not just higher rates but higher processing fees, premiums for riskier loans, tighter covenants, and/or the need to post additional collateral). And rising loan delinquencies (those not current on their loan payments) are forcing banks to charge more.

Consumers are feeling the pinch too. Credit card rates have jumped to 24%, used car loans to 14%, and 9% for new cars, all record highs, and overall U.S. consumer debt just hit a new high.

All of this should entail fewer new loans which means even less money circulating in the system. Normally, when credit flows are negative, GDP growth is too.

0 to 5 in a Year

That’s breakneck speed for a central bank—the Fed increasing from 0% to 5% was the steepest of the last several rate-hike cycles. And it’s not just via higher interest rates. The Fed’s tightening on other fronts too, which has removed money from the system. The Fed will likely now wait and watch for economic changes before adjusting short-term rates further.

While long-term rates appear to be headed higher as the market sells bonds, short-term rates are likely done rising. Inflation (PCE 4.2%), though far from central bank targets (less than 2%), has declined substantially while economic growth has slowed considerably, and the U.S. banking system can’t currently handle further rate hikes.

The LEIs (U.S. Conference Board’s Leading Economic Indicators) are rarely this negative and continue to fall, which has always indicated a pending recession. The Conference Board’s probability of recession model is now at 99%. It was only this high during the last 2 recessions.

Small business optimism index readings have collapsed to multi-year lows, which has negative implications for hiring and capital expenditures plans, also lowering the need for credit.

Would You Like Fries with That?

Apparently not. McDonald’s recently announced that more customers around the world are answering no to that question. Customers everywhere appear to be cutting back.

TJX Companies reported that its flagship TJ Maxx stores are suffering from shrinkage (that’s theft, not the reaction one may get from cold water). How does that even work? Are people stuffing shopping bags, wearing out multiple articles of clothing, or just leaving in new clothes, leaving the old ones behind? Either way, it’s noteworthy regarding vulnerable consumers.

Speaking of shrinkage, the U.S. money supply growth rate has been negative for several months—a highly unusual occurrence. It was falling at the steepest rate since the 1930s prior to the recent bank failures. This occurs infrequently and should inhibit growth. For this reason, and others noted above, bank credit is contracting. Office vacancies continue to rise too—San Francisco’s averaged nearly 30% this past quarter, which also doesn’t auger well for lenders or commercial loans in general. And corporate bankruptcy filings in the U.S. hit a 12-year high in early 2023. All this before a recession has even been revealed.

Not only has our signal triggered but the normal precursors to a recession are occurring. Layoff announcements continue, and average work weeks have shortened, a precursor to rising unemployment. That being said, the job market in the U.S. remains remarkably strong—the unemployment rate essentially hasn’t budged in the last year from record-low levels. But unemployment is a lagging indicator and job openings, albeit still relatively high, have fallen more than 20% from peak levels.

Inventories are being reduced. Investment spending is declining. In fact, there have now been 4 consecutive quarters of declining investment spending as a percentage of GDP. This last occurred during the Great Recession. And it just turned negative in Q1. Historically, when there have been 2 consecutive negative quarters (15 occurrences since 1950), a recession has followed on 12 occurrences. In Q1, overall U.S. GDP levels grew by a mere 1.1%.

The U.S. Purchasing Managers Index for manufacturing has shown contraction since last November. The PMI index for services has continued to be expansionary, bolstering the overall economy; however, it has declined markedly from its fall 2021 high. Major stock market bottoms around a recession have always occurred after the recession’s onset. And market bottoms coincide with manufacturing PMI bottoms. We’re not there yet.

And then there’s the U.S. debt ceiling, which is normally a non-issue but is still a concern with parties at loggerheads. More important, overall government debt in the U.S. and many other nations is way too high. With higher interest rates, the amount of interest now being paid on U.S. government debt has skyrocketed. Hopefully, budget cuts are coming but would also put a damper on economic growth.

Geopolitical risk, always a wildcard, is certainly heightened when we’re seeing images of Vladimir Putin and Xi Jinping embracing.

Too Long

The average investor allocation to equities is still high and dropping from recent levels near all-time highs. Allocations to stocks tend to fall rather abruptly during recessions which exacerbates selling pressure, ultimately resulting in capitulation.

Meanwhile, markets are overbought. Bullish sentiment is high. And volatility is unusually low. Investors appear complacent. The calm before the storm?

Earnings, though in decline since last summer, have continued to exceed expectations. In the most recent quarter, despite 80% of companies beating earnings expectations, the upside surprise was a mere 1% (by far the smallest of the last couple of years), while the results have primarily been supported by price increases since volumes are declining. Only 4 of the 11 key S&P 500 industry sectors had positive earnings growth. Bellwether Home Depot just reported that it expects its first annual sales decline in 10 years. Target also offered poor guidance as consumer purchases of discretionary items have waned.

Company conference calls are now replete with negative terminology such as “uncertain”, “challenging”, or “difficult”. The tone is clearly changing with the environment.

Valuations are somewhat out of whack. Unless inflation or interest rates are about to dive, today’s real yields suggest a forward price-to-earnings (P/E) multiple below prevailing valuations. The Nasdaq and S&P 500 P/E multiples of next-12-month estimated earnings are above their respective 20-year averages, even though interest rates are higher, which suppresses FMVs. This is somewhat astounding since prospects of a recession are high and earnings estimates are declining. And the key components of FMV—earnings, growth rates, and interest rates—are heading in unfavourable directions. To justify higher market levels in the short term, valuation multiples would need to expand, unlikely given the near-term prospects for earnings and interest rates.

There are elements of speculation as well. AI stocks are all the rage. The relative price strength of technology stocks versus the S&P 500 appears to be at the tail end of a massive multi-year spike only witnessed twice before–-the dot-com bubble in ’99/2000 and the Nifty 50 era in the late ’60s. Technology’s relative P/E versus the S&P 500 is 20% above its 20-year average. And the recent S&P 500 returns have been dominated by a handful of behemoths, a phenomenon usually only witnessed at market tops.

Our Strategy

While most believe we are enduring a slowdown, most don’t believe a recession is coming and have yet to react. Markets have risen year-to-date while the economy has held relatively steady. Since TEC^TM is alerting us to a recession, we remain comfortable with a less than fully invested stance. We prefer to maintain a hedge in place until the market sufficiently discounts a recession, or there’s a complete reversal of the economic outlook.

Meanwhile, we are comfortable owning undervalued positions with solid growth profiles, non-cyclical businesses lines, essential products or services, manageable balance sheets, and attractive returns on capital, even if they have been temporarily discarded by investors. And we have sold positions that have reached our FMV estimates or broken down in our TRAC^TM work.

To Make a Long Story Short

We anticipate a recession because last October our Economic Composite, TEC^TM, alerted us to a pending one. We remain wary of lower market prices that accompany economic declines. Markets are fully valued and appear too high relative to interest rates. Though we foresee a recession, we are open-minded about a muted, low-growth scenario, given the uniqueness of this cycle (Covid, massive stimulus, historically low unemployment) and the fact that we’ve already had a recession rolling through various sectors. However, something will have to go off-the-rails before central banks lower rates since they are concerned about refueling inflation, as in past cycles.

Complacent government officials, businesses, employers, employees, and investors will mostly be caught off guard by a recession, which should create job losses, weaker profits, bankruptcies, and declining share prices. While most believe a slowdown is upon us, they don’t see a recession, nor have they reacted yet. Sectors that are usually down as a recession is approaching, such as Industrials and Materials, have barely declined.

As such, we will continue to hone our short game—hedging portfolios—while playing the long game—owning high-quality companies we expect to grow their earnings and underlying valuations. A 7-page letter. Not quite short and sweet. But we’re trying.