What Does a Yellow Light Mean?

This article has been excerpted and edited from our quarterly newsletter to clients dated May 17, 2022.

“What does a yellow light mean? Slow down! Okay. Whaat dooes. a yellllow liight mean?” That’s from our favourite episode of the sitcom Taxi when Jim was taking his driver’s test. It’s a classic. Here is the link to a brief clip if you haven’t seen it, or even if you have: https://www.youtube.com/watch?v=39k067hcgYY.

Global economies had been growing at an unsustainably high rate, and growth was bound to slow. Now, numerous factors are acting to slow GDP growth: less accommodation from central banks, including interest rate hikes leading to higher borrowing costs; removal of direct government stimulus cheques; deleterious impacts on Europe from Russia’s incursion, not to mention the mass exodus from Russia by western companies; Chinese lockdowns; a strong USD; and the impact of the inflationary spike on pocketbooks and profit margins.

Spotlight on Inflation

Most believe we are destined for a recession, if not already in one. Between the negative sentiment and the stock price valuation reset that needed to take place, it’s not surprising that the markets have meaningfully softened.

While the economy is clearly slowing, we do not foresee an imminent recession. Our Economic Composite (TEC^TM) has called every recession in advance since the ’60s (based on backtesting and actual experience in 2020), without a false signal—each of the 9 times it alerted to a recession, one occurred shortly thereafter. Importantly, a recession has not occured without a preceding signal. And TEC^TM is not alerting us to one now in any major economy. In such a frenetic period TEC^TM may not detect a recession but if conditions deteriorate further, our multi-pronged risk-management approach, which also considers market momentum and valuation, should still allow us to act.

The consumer, who represents nearly 70% of economic activity, is in better shape than their sentiment would suggest. Unemployment is at lows; wages are rising; debt service ratios are low, and savings rates are relatively high.

In Q1, major supply chain adjustments in the U.S. caused exports to increase by only 6% while imports jumped 18%, and lower inventories also reduced GDP, producing a 1.4% contraction. If Q2 is similarly weak, we could see a technical recession (2 quarters of negative growth). But it would likely be shallow. “Sales to domestic purchasers” in Q1 increased by 2.7%, an indicator of continued consumer strength which, again, drives most of GDP.

With inflation dampening consumer confidence, consumer sentiment is already at levels normally associated with deep recessions. This should provide a natural softening of demand, which along with central bank dampening efforts (printing less money) should quell inflation (U.S. core PCE dipped recently to 5.2% after hitting a 40-year high). Repairing supply chain issues, which have been slow to dissipate, should ultimately help reduce price pressures too. We are already seeing signs of commodity price peaks, both for industrial commodities and food and energy related ones (isn’t it like the numbers at the gas pump are wrong?). Meanwhile, overall disinflationary pressures from poor demographics and high government debt which suppress growth, and the technological productivity revolution which keeps prices in check, haven’t dissipated.

Lower Growth Heightens Volatility

But as everything slows, so do returns. Concerns abound about falling earnings and valuations. Year-to-date performance is showing the worst start for the stock market in over 50 years. With 10-year Treasury yields having essentially doubled from year end, bond returns are also poor. These asset classes are normally negatively correlated. But interest rates are reverting from such low levels that they needed to adjust higher despite the economy slowing, especially given high inflation rates. Nearly all asset classes have suffered materially. From their highs, the following are down significantly: Nasdaq 26% (enduring its worst YTD decline in its history), S&P 500 16%, All Country World Index 17%, Russell 2000 (small caps) 27%, High-Yield bonds 13%, and Preferred shares 19%.

We have been cautious, wary of elevated valuations and economic deceleration. We saw the yellow light flashing. Therefore, we have held cash, avoided expensive stocks (as always), maintained hedges by shorting the U.S. stock market (or via an inverse long), and purchased highquality companies that had already suffered declines, where we believed prospects were appealing notwithstanding a slowing backdrop.

RED LIGHT DISTRICT

Here’s where we still don’t want to go—where the unsavoury investments are found. We continue to avoid unprofitable over-hyped companies whose valuations haven’t fallen enough to reflect their underlying realities. The list of once high-flying companies that have suffered more than 70% declines from highs keeps growing (e.g., Shopify, Netflix, PayPal, Robinhood, Peloton, AMC Entertainment, Roku, Zoom).

Most cyclical companies aren’t attractive either. Their revenues are susceptible to lower volumes and poorer selling prices while costs remain vulnerable to inflation. Too many investors are still overweight commodity stocks. Taxi drivers have mostly forgotten about cryptocurrencies and want to discuss energy stocks.

Elevated input costs, including raw materials, shipping, and salaries should hamper most companies’ profit margins, where they can’t pass along price increases to offset their ascending costs. That’s why Amazon mentioned inflation 23 times in its earnings transcript. Everything was inflating except its stock price.

At the same time, revenue growth is likely to weaken, further impacted by foreign exchange rates too as a strong USD restrains international receipts for U.S. companies.

We are looking for companies that can somewhat control their destiny. Earnings growth is driven by revenue growth and margin enhancements, and both may be under pressure for most companies. On conference calls, companies are talking down growth or talking up costs, or both.

Interest rates at the administrative short end of the yield curve have much further to rise as monetary authorities react to control inflation. The bond market has reacted well in advance though. The 10-year Treasury yield having more than doubled off the bottom. After touching 3.2% recently, up from 1.2% less than a year ago, it may level off, or even decline if softening persists. However, bonds generally still don’t offer attractive yields. Though, high-yield is much more attractive than in the recent past since yields have jumped to 7.5%. But many of these issuers are over-levered and may struggle to meet obligations if profits are under pressure. Not to mention, refinancing should be more difficult in this environment—higher rates, uglier fundamentals, and nervous lenders.

GOING GREEN

When everyone else is turning negative, we tend toward positive. Not because we’re contrarian for the sake of it. But better investment opportunities are presented when sentiment turns so negative. Though there is still some room to decline, we believe this outsized correction is close to bottoming.

Bullish sentiment has now collapsed to 30-year lows. Surveys recently exhibited the lowest reading since 1992. Oddly, participants weren’t yet practicing what they were preaching, and stock ownership had not turned meaningfully lower. Once enough selling takes place, showing that investors have generally capitulated, a bottom should be in place.

The seasonal slump period (sell in May and go away) is almost always worse during this lead-up period to U.S. mid-term elections, where the markets are down slightly on average from May through November. But then the market has its best seasonal period post the November elections, where the S&P 500 has lifted by an average annualized 21%, without a single decline since 1900.

Furthermore, in periods when the sentiment reading was this low, stocks were higher one year later in 37 of 38 occasions.

These two stats coalesce our outlook. Though sentiment is pessimistic, investors have yet to sell in droves. Purchases of double leveraged ETFs and call option buying have only recently turned down from euphoric highs. Institutionally, pessimism is high too, near ’08 levels; however, portfolios are still overweighted in equities. We expect widespread selling to occur soon and lead to a meaningful bottom.

Meanwhile, reported earnings are still outperforming analyst estimates. And expected earnings remain on the rise. This is the most important longer-term factor for stocks. And we don’t get too worried until a recessionary signal occurs that would bring along with it deteriorating earnings and falling valuations.

Consumer sentiment may be negative, but the job market remains rock solid. In the U.S., there are over 11 million openings, up from a recent 7 million monthly average.

Company insiders haven’t tilted to the sell side—a good sign for both company fundamental prospects and valuations.

The world’s insatiable attraction to the U.S. dollar should help support U.S. financial assets too. We continue to hold mostly U.S positions.

OUR STRATEGY

We were too early with our hedges, reinstating them in mid 2020, after successfully hedging in early 2020. We believed the market had fully recovered to its fair market value (FMV), despite pandemic headwinds. Then the government stimulus, accompanying demand spike, change in the U.S. government, and advent of vaccines propelled the market into overvaluation.

Though our timing was off then, we seem to be back in sync with the markets. And we’ve been honing our TRAC^TM index tools to better time overall market and sector ups and downs. It appears that the S&P 500 has another 5-10% to fall. That would place it one TRAC^TM floor down from its peak—the maximum for a correction outside of a recessionary period. Since WWII, only 4 declines without a recession exceeded 20% with an average of those declines of 28%. Furthermore, of the 25 non-recessionary corrections where the S&P 500 fell by less than 20% since WWII, they lasted a median of 89 days. The current correction is already at day 135.

Our goal is to lose less than the market on the way down and outperform on the way up (that should always be your money manager’s objective)—the problem was we didn’t anticipate the market rising like it did in 2021. And we needed to wait patiently until the markets regressed.

In our view, our portfolios are now the highest quality since our inception. Features of our holdings include competitive advantages (brand recognition, market share, low costs), high returns on capital, substantial free cash flow, low leverage, impressive growth, and meaningful undervaluation versus our FMV estimates. Our convictions are high for our current holdings, and we are looking to take advantage of any further market weakness to average down in some and add new investments in others.

Tackling inflation may not be so easy now that price increases are more broadly based. Central banks may need to react more aggressively than we’re anticipating. If that’s the case then market valuations may have much further to fall as valuations could drop to below-average levels. This is another aspect to be mindful of as we look to reduce our hedges.

SPOILER ALERT

The economy is slowing, even without central bank tightening which will further dampen economic activity. We don’t believe a recession will result since overall demand remains robust. Our Economic Composite suggests the same. Though, of course, we’ll monitor it diligently for an alert to a cycle peak. In turn, inflation should naturally moderate without overly aggressive monetary tightening.

Valuations have compressed, leaving the markets reasonably valued. Because headwinds are in place, we continue to invest in companies we believe are less susceptible—both less reliant on economic growth and already materially undervalued. Since markets have begun to throw the babies out with the bathwater, we have been comfortable deploying capital into investment opportunities where prices have become unduly depressed.

There was no wall of worry until recently. It has been partially rebuilt. Slowdowns can trigger accelerations in market activity as we’ve recently witnessed. Both on the downside as panics ensue and spikes that follow once capitulation passes and prices revert. The markets may fall somewhat further but a prolonged decline, without a recession, seems improbable. It should be difficult for markets to fall too far while underlying values continue to rise. We believe the share prices of high-quality companies trading well below FMVs should do well, especially if the markets continue to rotate from growth to value. While the yellow light turned red, we expect it to change to green shortly. Stay tuned.