Foraging for winners in the smoldering wreckage of 2022’s charred cross-asset landscape conjures The Road, when Viggo Mortensen and his son find a surviving can of Coke — a nostalgic red beacon in a post-apocalyptic monochrome.
Raw materials have worked. Nothing else has. With the Fed set to deliver several more rate hikes and the prospects for risk assets bleak, it’s possible that cash will be the runaway “winner” in 2022, second only to commodities.
The updated figure (below) illustrates the most challenging investment environment since the financial crisis.
In some ways, 2008 was easier to navigate. Obviously, losses were larger then, especially in equities, but 2022 isn’t over. And the worst bond selloff in modern history makes things more vexing for multi-asset investors.
This week was the first in 2022 during which the S&P, Treasurys, IG, HY and commodities all rallied together. For most of this year, major assets sold off pretty much in tandem, often exacerbated by surging commodity prices.
Amid the despair, it’s important not to lose perspective. This year’s “losses” come on the heels of what might fairly be described as the most spectacular rally in modern history, all things considered.
Note the grey shaded areas in the figure (above). The first covers the selloff from the September 2018 peak through the end of that year. That episode was harrowing and yet, it appears as little more than an oscillation in the long shadow of the pandemic rally. The second shaded area shows stocks are just now negative on a 12-month basis. Of course, if you adjust a slightly negative 12-month return for 8% YoY inflation, you’re left to ponder a sizable real loss, but I’ll leave that aside having discussed it ad nauseam previously.
There are two ways to look at this. The glass half-full take is just that markets have endured a very painful five months and notwithstanding a historic drawdown in bonds, very large losses in credit, 50%+ declines in speculative corners of the market and a near-bear market in the S&P, it’s barely a scratch if you rode the index up from the March 2020 lows.
The glass half-empty assessment, which is probably the “better” take here, is that this is nowhere near over, or at least not for stocks. Yes, a bear market rally was inevitable after seven straight weekly losses on the world’s risk asset benchmark par excellence. And yes, there’s a case to be made for additional near-term gains. But remember: Higher stocks, lower bond yields and a softer dollar are all conducive to easier financial conditions. That’s the opposite of what the Fed wants.
All pretensions to protecting the American Everyman/woman aside, the Fed needs the US consumer to crack. “If consumer data points are strong, they will signal financial conditions have not tightened enough and risk assets will fade,” Dennis DeBusschere said.
“The upward inflation spiral is teetering on heading to a very painful place,” JonesTrading’s Mike O’Rourke wrote, noting still nosebleed prices for oil and natural gas. “The longer markets continue to deny the reality of the need to reprice and tighten financial conditions, the more leeway the FOMC has to continue to tighten,” he added.
It was easy to call 2008 comeuppance. A punishment deserved for recklessness on the part of… well, everyone, if we’re being honest. The tragedy wasn’t so much that regular people had to come to terms with the reality that one’s home typically bears some vague resemblance to one’s financial circumstances, but rather that regular people had to face the music, while Wall Street, sans a few sacrificial lambs, got a free pass funded by Main Street.
It’s a lot more difficult to call 2022 comeuppance. Millions of people are dead from a viral scourge and war is exacerbating the world’s food and energy crisis. Of course, you could argue that we (the global community) should’ve been better prepared to cooperate to preserve the species in the event of a pandemic. And you could argue that delaying the energy transition for decades set the stage for the current crisis. The same could be said of sustainable agriculture, and so on. But no one wants to say any of that because, again, people are dead and still dying.
For risk assets, the case for a 2008 redux is best made by reference to the fact that the emergency policies deployed to save the day then aren’t available now, because we had to exhaust them in 2020.
And besides, we haven’t had a “good” panic yet. “Few trust the ultimate equity lows have been printed,” BofA’s Michael Hartnett said, citing feedback from the bank’s London clients. “The selloff to date is too orderly,” he added. “A serene stock market selloff is no selloff at all.”
Waiting for the high drama of a real capitulation maybe like waiting for Godot.
I have been hearing that the market has priced in the interest rate hikes and the Feds balance sheet run off (which starts next week). However, I am betting it hasn’t. I bought heavily in the last few weeks and I have been selling the rally. This definitely has that feeling of gambling lol. IMHO I think the market remains very volatile until we are done with inflation and interest rates settle down. I don’t own a house so I will remain 50% in cash for the next couple of months, I am too close to retirement to get hit by a 40% loss.
From TV show Seinfeld – “serenity now, insanity later.” Sorry, couldn’t help myself.
Wrote a well crafted, impeccably reasoned, comment, and lost it with an errant keystroke. So here’s the short , sloppy version:
Let’s be the Devil’s Legal Counsel.
Markets normally bottom because fundamentals break down so badly that some (not all, but enough) investors capitulate.
Investors capitulate (mostly) because they lose confidence in their understanding of what is happening or how bad the fundamentals will get. They start saying things like “OMG WTF is going on” “this looks bottomless” “I have no idea how bad this will get” and they panic and give up, liquidate messily, etc. Think back to 2008/09 when people were fearing the next Great Depression. (There is also rules-driven and liquidity-driven capitulation.)
Can markets bottom WITHOUT capitulation?
Scenario: fundamentals are good, when an external actor starts gradually forcing prices down. That actor tells investors what it is doing, what it will do next, and how long it will do it. Fundamentals don’t break down, most investors don’t lose confidence. The actor reaches its well-advertised stopping point. Market bottoms. Without capitulation.
Is that scenario possible? Could we be in it?
It is NOT my base case scenario, which may be because it is not my desired scenario. I “want” a good old fashioned catharsis of a wipeout. 1/ It would feel “righter”, I think the SP500 remains overvalued by mid-teens percent, there are still big investor darlings to be taken out, and honestly I’d sure like to be able to take the summer off (figuratively).
Nevertheless, you have to wonder: what happens if PCE inflation recedes two or three points in the next few months, corporate profits take a couple steps down but don’t look to tumble down the whole flight, and the Fed signals that after the summer’s 50s it’s done. Could the capitulation never happen?
1/ I don’t want anyone to get hurt, of course. If traders are going to jump from windows, let those be WFH home office windows and the fall be a roll into the petunia patch.
The government/Fed’s response to the covid-induced swoon in the stock market taught the retail investors one very important lesson: if a recession gets bad enough, the government/Fed will increase liquidity. It won’t take long for the liquidity to start flowing either, we just have to wait for it.
During economic times that lean inflationary for a relatively short period of time (as the current situation seems to be), unless a retail investor is wired with “trader-DNA”, most retail investors realize their chances of trying beat the long term SPY return are slim to none. Therefore, they stay invested and, if necessary, compensate for a declining investment account balance by deferring the next major purchase they would like to make until supply/demand is back in balance and prices stabilize/drop.
I doubt I am alone in having been taught this tough lesson: even if you are smart/lucky enough to time getting out of the stock market right before a “swoon”, you still have to get back in at the right time to make it financially worthwhile. Also, at least for me, I don’t want to sit in cash- with a guaranteed 8% loss of my buying power.
You can’t fight the Fed… they and many Billionaires – because losing $80M a year in purchasing power hurts), are far more worried about Inflation so they’ll keep turning the screws until they’re sure.
This rally (which I hope to make a few percent before it collapses) will only reinforce to them that there’s more cash to disapparate. So it’s not timing the market, it’s timing their statements.
One of H’s posts, which I can’t find right now or I’d drop this comment there instead of here, had a chart showing corporate earnings decline in each recession. There was a wide range, from a mid-single-digit in many past recessions to a high-teens drop in the GFC.
Many, including me, think the coming recession is likely to be more mild than severe. Some bulls even say we are headed for not a recession, but merely a “normalization”. Does that imply that the coming earnings decline will also be small?
I believe that the “pandemic winners” have been over-earning in the past year. EBIT margins have been unnaturally high, in my view driven by pricing power, higher volumes, and operating leverage on fixed costs. Managements are saying that they have re-invented their companies to be structurally more profitable, but in most cases I doubt that is true. I think that when the recession takes hold – or, if you’re more bullish, when conditions “normalize” – we should see growth and margins revert to pre-pandemic levels.
In 1Q, some companies, mostly in particularly consumer-facing sectors, started missing and/or guiding down. Many of them guided to a sharp downshift in growth and margins, in some cases back to pre-pandemic levels.
For example, TGT was a low-single-digit topline grower with 6%-ish EBIT margin for years, before the pandemic turned it into a super-grower darling with 8.3% EBIT margin. Management was saying the new Target will deliver >8% EBIT margins. Post-blowup, consensus has topline growth going back to low/mid-single-digit and EBIT margins back down to 6%-ish.
So I looked at this hypothetical scenario.
Take all the companies in the SP500, and see how much their consensus 2022 EBIT margin has changed from actual 2019 EBIT margin, then roll this up by sector and for the index, market-cap weighted. One sector has a decline, Financials. Two sectors have >1,000bp increases, Energy and Healthcare. The rest have from +0bp to +500bp. For the index, the change is +500bp. That is, I think, consistent with my view that large companies are over-earning.
For 2023, assume that 2023 consensus revenue is correct, and assume that 2023 EBIT margin reverts to actual 2019 EBIT margin, and see how that changes 2023 EBIT from current consensus 2023 EBIT. Three sectors would see 2023 EBIT over 30% below current consensus 2023 EBIT, Discretionary, Energy, and Healthcare. Three would see mid-to-high-teens percent below, Financials, Technology and Materials. The rest would see low-to-mid-single digit below. For the index, this scenario results in 2023 EBIT -18% below current consensus 2023 EBIT. In other words, earnings estimates for 2023 would have to be cut by high-teens percent, allowing that EPS decline may be a little less than EBIT decline (due to share count, etc). That is, if my memory of H’s post serves, similar to the GFC earnings decline.
The next step is to apply the hypothetical 2023 earnings to whatever you think the appropriate trough multiple should be, for the company, sector, or index.