Aversion to Reversion

This article has been excerpted and edited from our quarterly newsletter to clients dated August 24, 2023.

There’s a reason that value investing works. Stock and bond prices fall away from underlying fair market values (FMVs) because of fear, panic, disdain, impatience, frustration, shortsightedness, misperception, cursory analysis, or indiscriminate selling. But, over time, when these issues dissipate, prices revert to underlying values, assuming those values have not eroded. Most don’t practice value investing—instead relying on buy and hold, momentum, or index strategies, all much easier on the psyche in the short term. To us, it’s simple common sense to embrace mean-reversion strategies—those offering better upside potential, especially during a period when most securities have downside risk since they are already at or above FMVs.

Bearish Aversion

In the last several months, stock prices lifted higher in an emotional blowoff. Led by a small number of mega-cap tech stocks, the Nasdaq and S&P 500 have been propelled higher. This has been driven by a few factors. The threat of a recession shifted investor sentiment away from cyclicals and toward growth stocks. Lower inflation is accompanied by higher earnings multiples. Bank failures scared investors out of financials to “safer” stocks. And anything associated with Artificial Intelligence has been met with overexuberance.

We agree with embracing more stable, noncyclical businesses—we’ve done the same. However, the market has overly prized certain major companies, lifting valuations too high, and in return imposing vulnerabilities on them and the overall major market indexes. At the same time, our Economic Composite (TEC^TM) warned of a U.S. recession 10 months ago, the exact average historic lead time to a peak in the economic cycle. TEC™ warned about other countries too, which have either entered a recession or are exhibiting no growth. A U.S. recession should be imminent. At the same time, the major U.S. market indexes have run back up to TRAC^TM ceilings, where the markets also topped at the end of 2021.

Signs of a pending substantial decline are in place, yet most investors appear complacent. Similarly, just prior to the last 3 recessions, other than in 2020, a spike in articles discussing a soft landing (avoiding a recession) also occurred—right as interest rates were peaking, and just prior to the recessions’ onsets.

A soft landing is the consensus view despite data, such as the Manufacturing PMI, which still points to contraction. Some, who expected a mild recession, no longer foresee one. Unemployment in the U.S. remains at 3.5%, near all-time lows, sustaining economic growth. This is a lagging indicator though. The impact from central bank tightening and higher interest rates takes time to filter through the economy. Most don’t see economic reversals, because it’s easier to extrapolate, it’s hard to foresee, or they simply don’t want to—an aversion to reversion.

Economic Reversion

The economy has been running at full tilt—fueled by full unemployment, high consumer spending from excess savings (government handouts), and record corporate profits (above-average profit margins). Central banks have been tightening to slow the pace and quell the resulting inflation.

It appears to be working. The most recent U.S. core PCE was up 4.1% annually—the lowest rate since September 2021. And the CPI’s current monthly streak of year-over-year declines is the longest one since 1930.

But it’s difficult to slow down economic growth without causing a recession. Central banks have been shrinking balance sheets—negative money growth does not auger well for economic growth. Monetary conditions eased when a few banks failed, but after a brief blip, they tightened again.

The U.S. PMI index (manufacturing and services) has fallen for 6 months straight. It’s still exhibiting growth, but conditions are weakening. The services sector is propping up the economy because the manufacturing sector has been contracting for 11 months consecutively. The contraction is even worse in Europe. And June’s data pointed to a 0.2% GDP decline in Canada.

A low manufacturing PMI and inverted yield curve are precursors to recession, which in turn begets higher unemployment and loan delinquencies. And a recession has always followed when banks have tightened credit as much as they have recently.

The impact from short-term interest rate increases and the inversion of the yield curve are now being felt. U.S. mortgage rates are pushing 8% and car loan rates even higher—both at levels not seen since 2007. Car loan delinquencies are at a 17-year high.

Commercial real estate is problematic with work-from-home now engrained, despite even ZOOM’s employees having to return to the office 2 days a week. U.S. office vacancies exceed 18%—a 30-year high. This could prove problematic for overexposed banks.

Retail sales have been relatively strong, but the mix has shifted from discretionary items to necessities. At the same time, U.S. credit card debt has accelerated to all-time highs, along with interest rates on those balances which exceed 22%. In the early part of the pandemic, sales of goods shot up while services waned. Since then, consumption of goods has fallen off while services spending has risen. Services should slacken too, especially if unemployment rises. It won’t help that wage growth isn’t keeping up with inflation.

And productivity (output per hour) has been poor. Though, employees are more satisfied with work from home. We also now have concepts such as “unlimited paid time off”—meaning as many vacation and sick days as desired as long as one fulfills job duties. This can’t help waning productivity. Forget about work from home—how about work from nowhere? About 8% of U.S. companies now offer unlimited vacations. Isn’t that retirement (with pay)?

Meanwhile, companies are dealing with much higher borrowing costs, tighter credit standards (credit is already contracting—unusual prior to a recession), inflated material and labour costs, and slower volume growth. This doesn’t bode well for capital spending or hiring (read business investment or consumer spending—the brunt of GDP). In fact, small business confidence just suffered its 19th consecutive month below average.

Mounting Obligations

Government debt levels are too high. When they’re this high as a percent of GDP, it significantly stifles growth, as it has for the last decade.

And debt levels (including budget deficits) nearly always worsen in recessions, with government fiscal policies utilized to spend its way out.

Already high interest rates could be vulnerable to further increases to entice investors, since the amount of bonds the U.S. government must issue over the next year exceeds $1 trillion—to fund ballooning deficits, and cope with the increased interest expense on the ever-growing debt burden.

None of this is going unnoticed by rating agencies—Fitch recently downgraded the U.S. government’s credit grade to AA+.

Meanwhile, U.S. government spending is out of control with multiple fiscal initiatives (e.g., Inflation Reduction Act, CHIPS and Science Act) about to kick in, while tax receipts are falling. And when debt is already too high, material spending initiatives tend to have deleterious effects on economic growth. The annual decline in U.S. Federal tax receipts is well in excess of the magnitude that normally precedes a recession.

With lower growth, and a likely recession, we expect inflation to fall meaningfully. Disinflationary forces are reasserting themselves too: poor demographics (i.e., slower growing populations); globalization (laws of comparative advantage keep costs and prices low); high debt levels (as noted above suppress overall growth); and technology (forces costs and prices down along with the Internet’s price discovery aspect). Once central banks are comfortable that inflation has peaked, interest rates should have their own reversion—to lower levels.

Valuation Distortions

Still, the North American stock markets are overpriced, especially incorporating interest rates. The earnings yield of stocks (P/E ratio reciprocal) would normally be much higher than 10-year U.S. government bond yields. And it has declined below T-bill yields, which rarely occurs.

Short-term rates now provide attractive yield alternatives, a competitive threat for stocks and longer-term bonds. The real yield on 2-year government bonds is now 1% (and rising), much higher than the negligible, often negative levels, of the last 20 years.

Corporate insiders are attuned. Recently, fewer than 3 U.S. large cap stocks have had insider purchases for every 10 with sales, and the amount of selling has been relatively outsized. This makes sense to us since the indexes are at or above our FMV estimates—unusual, considering slipping unit volumes, anemic sales growth, and flatlining profits.

For perspective, the Nasdaq trades at 26x next 12 months’ earnings compared to its average 20-year earnings multiple just under 20x, during a lower interest rate environment which enhances values. Similarly, the S&P 500 is at 19x versus its comparable multiple of less than 16x.

Various measures of market sentiment point to levels of optimism that appear inconsistent with our outlook for the economy and corporate earnings.

Chinese Diversions

Growth in China is slowing (to the point where its central bank is having to stimulate by lowering rates when everyone else is tightening), attributable to fallout from real estate overbuilding, slowing exports, and poor demographics (an aging and shrinking population—deaths exceeded births last year). China, the world’s second largest economy, has been a material driver of global growth for years. While its burgeoning middle class should continue to expand for years to come, China’s contribution to global growth could be lessened, especially in the short term.

Furthermore, while it’s impossible to predict whether China will invade Taiwan, it’s certainly a possibility given the irrational mentality of China’s leadership. China has already tipped its hand by annexing Tibet, Nepal, the Uyghur region, and Hong Kong.

A massive military buildup and drills regarding a Taiwan invasion are well underway. Opposing officials in the Chinese government have been neutralized. Air raid shelters as well as medical facilities close by an invasion launch-point have been built. Clearly, an invasion, or even a blockade limiting food access, would be extraordinarily disruptive politically. Economically, it would be highly disruptive since China is the world’s largest exporter and Taiwan is the leading producer of semiconductors.

Our Strategy

With stock market valuations high, markets at TRAC^TM ceilings, excessive debt levels, relatively high interest rates, and the prospect of a recession (our TEC^TM alerting us 10 months ago), we continue to invest cautiously—holding some cash and a short position as a partial hedge until the market sufficiently declines or our outlook for the economy alters. Though we expect a recession, it may be a muted, low-growth one because the massive stimulus and ultra-low unemployment have created somewhat of a cushion.

In the meantime, we continue to hold many undervalued positions with outlooks for satisfactory growth, noncyclical business lines, manageable balance sheets, and attractive returns on capital.

Reversion Therapy

In 2013, just over one-third of all U.S. equity funds were indexed versus nearly 60% today. Investors may embrace the markets but keep giving up on reversion strategies such as value investing.

Over the last 30 years, the S&P 500’s earnings per share grew by 7% annually while the performance of the index averaged a similar amount. There is clearly a direct correlation between earnings growth and stock market returns over time. Our concern today is that earnings growth won’t keep up near that pace—too many economic headwinds. In addition, the markets appear to need at least a short-term adjustment downward to correct stretched valuations.

And it’s been 10 months since our Economic Composite warned of a U.S. recession—the exact historical average time from a signal to a recession’s onset. This should only further pressure downward reversion. Yet most remain complacent, believing it’s only a slowdown.

We continue to embrace our reversion strategies. Hedging portfolios when we’re fearful of outsized market declines and buying undervalued, high-quality companies that we expect to revert higher to our estimated FMVs. Our goal is to outperform. Therefore, we need to recognize aversion in others and to try our best to benefit from ongoing reversion.