Tall Expectations Warrant Short Exposure
RJ Steinhoff, CFA Investment Process
Many indicators of past economic slowdowns are now sounding an alarm. Yield curves in most major economies around the world are inverted. Leading economic indicators and business sentiment surveys have negatively triggered. Signs of stress in the financial system are emerging. Our own Economic Composite (TECTM) alerted us to a potential recession in the U.S. and several other countries in the second half of last year. S&P 500 earnings expectations for 2023 have declined 11% since last June. A recession appears imminent.
Unemployment is near record lows, though a lagging indicator and typically at its nadir at the end of the business cycle. Cracks are appearing; employers are becoming increasingly cautious, with numerous companies announcing layoffs, hiring freezes, or restructurings. Unemployment may not rise as significantly as in past recessions for various structural reasons, but a rise should be expected. Recent quarterly earnings calls have been anything but upbeat regarding the general near-term outlook.
Despite these bright red lights, investors appear sanguine. The implied growth embedded in U.S. equities is presently a lofty 4.7% (see Chart 1, below). While down from the peak of 6.3% registered before the 2022 correction (when we argued that equities were the most expensive in history), equity valuations imply smooth sailing ahead for the U.S. economy. However, we know from history that recessions are rather unfavourable for equity prices—since 1965, two-year rolling losses of 20% or more have always been closely preceded by a peak in the business cycle.
CHART 1. S&P 500 IMPLIED GROWTH. MARCH 31, 1999 to MARCH 10, 2023
SOURCE: FACTSET, GENERATION IACP
How do we explain the disconnect between the high implied growth rate and blinking red lights?
1. Markets expect a soft landing
While most economists expect a recession in the next 12 months, the unemployment rate is forecast to peak at only 4.9%, well below prior cycles. This implies a shallow recession, cooling inflation, limited interest rate hikes, and cuts as early as the end of this year. In other words, a soft landing. Equity investors buying stocks at this juncture expect to skate through just a small bump in the road, with the dangling carrot of monetary policy tailwinds heading into 2024.
2. Complacency—ignorance is bliss
Even a cursory examination of historical bear market declines reveals a recurring pattern—markets contentedly ignore troubling economic data points until the evidence is overwhelming (usually accompanied by a galvanizing catalyst). Then markets quickly unravel, often in a waterfall pattern, a stark contrast to the upward meander during economic expansions.
In 2006, then Federal Reserve Chairman Ben Bernanke famously shrugged off the inverted yield curve as a harbinger of a slowing economy. In 2019, Bernanke’s successor, Janet Yellen, also dismissed the inverted yield curve while our own Economic Composite was alerting us to a pending recession.
In Chart 1, elevated implied growth can be seen before the 2001 and 2008 recessions—all while troublesome economic data points were piling up.
High valuations and weakening economic data warrant caution. We continue to hedge (shorting equity indexes) against broad market declines as the economic picture worsens. On the long side, we own companies that have demonstrated the ability to generate high returns on invested capital throughout an economic cycle or unique situations—restructurings, spin-offs, merger arbitrage, corporate activism—which may work even as the economy deteriorates. Companies less tied to the business cycle should be emphasized, such as consumer staples, telecommunications, and health care, since these groups tend to outperform in recessions.
RJ STEINHOFF, CFA
HEAD OF RESEARCH
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation IACP Inc. may or may not continue to hold any of the securities mentioned. Generation IACP Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation IACP Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation IACP Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
Many indicators of past economic slowdowns are now sounding an alarm. Yield curves in most major economies around the world are inverted. Leading economic indicators and business sentiment surveys have negatively triggered. Signs of stress in the financial system are emerging. Our own Economic Composite (TECTM) alerted us to a potential recession in the U.S. and several other countries in the second half of last year. S&P 500 earnings expectations for 2023 have declined 11% since last June. A recession appears imminent.
Unemployment is near record lows, though a lagging indicator and typically at its nadir at the end of the business cycle. Cracks are appearing; employers are becoming increasingly cautious, with numerous companies announcing layoffs, hiring freezes, or restructurings. Unemployment may not rise as significantly as in past recessions for various structural reasons, but a rise should be expected. Recent quarterly earnings calls have been anything but upbeat regarding the general near-term outlook.
Despite these bright red lights, investors appear sanguine. The implied growth embedded in U.S. equities is presently a lofty 4.7% (see Chart 1, below). While down from the peak of 6.3% registered before the 2022 correction (when we argued that equities were the most expensive in history), equity valuations imply smooth sailing ahead for the U.S. economy. However, we know from history that recessions are rather unfavourable for equity prices—since 1965, two-year rolling losses of 20% or more have always been closely preceded by a peak in the business cycle.
CHART 1. S&P 500 IMPLIED GROWTH. MARCH 31, 1999 to MARCH 10, 2023
SOURCE: FACTSET, GENERATION IACP
How do we explain the disconnect between the high implied growth rate and blinking red lights?
1. Markets expect a soft landing
While most economists expect a recession in the next 12 months, the unemployment rate is forecast to peak at only 4.9%, well below prior cycles. This implies a shallow recession, cooling inflation, limited interest rate hikes, and cuts as early as the end of this year. In other words, a soft landing. Equity investors buying stocks at this juncture expect to skate through just a small bump in the road, with the dangling carrot of monetary policy tailwinds heading into 2024.
2. Complacency—ignorance is bliss
Even a cursory examination of historical bear market declines reveals a recurring pattern—markets contentedly ignore troubling economic data points until the evidence is overwhelming (usually accompanied by a galvanizing catalyst). Then markets quickly unravel, often in a waterfall pattern, a stark contrast to the upward meander during economic expansions.
In 2006, then Federal Reserve Chairman Ben Bernanke famously shrugged off the inverted yield curve as a harbinger of a slowing economy. In 2019, Bernanke’s successor, Janet Yellen, also dismissed the inverted yield curve while our own Economic Composite was alerting us to a pending recession.
In Chart 1, elevated implied growth can be seen before the 2001 and 2008 recessions—all while troublesome economic data points were piling up.
High valuations and weakening economic data warrant caution. We continue to hedge (shorting equity indexes) against broad market declines as the economic picture worsens. On the long side, we own companies that have demonstrated the ability to generate high returns on invested capital throughout an economic cycle or unique situations—restructurings, spin-offs, merger arbitrage, corporate activism—which may work even as the economy deteriorates. Companies less tied to the business cycle should be emphasized, such as consumer staples, telecommunications, and health care, since these groups tend to outperform in recessions.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation IACP Inc. may or may not continue to hold any of the securities mentioned. Generation IACP Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation IACP Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation IACP Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
