IN-DEPTH: TRANSCRIPTION - LONGWave - 05-11-22 - MAY - Recessions & PE Compressions
Thank you for joining me. I'm Gord Long.
A REMINDER BEFORE WE BEGIN: DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are COMMENTARY for educational and discussions purposes ONLY.
Always consult a professional financial advisor before making any investment decisions.
When a market starts to conclude that a Recession is near what does it do? Often earnings are still good and only later seen to have been near their peak. What the market starts dong is discounting future earnings. This is difficult to assess, since as to how deep and long the recession will be is still very much unknown. Growth will go down but by how much?
For a very long time we have not witnessed a Recession led by major rises in Inflation. In this case the discounted cash flow of future earnings is easier to assess – at least based on current Inflation and Inflation expectations. This is the case today. Many see a Recession with high inflation. This normally results in larger than normal PE Compressions.
Therefore, I want to explore PE Compression in this month’s LONGWave. As such I want to discuss the subjects listed here.
Let’s start with what might be the timeline for a possible recession.
Heading into the first estimates of Q1 GDP, estimates were low - certainly far lower than the 6.9% final Q4 GDP number, the strongest since the third quarter of 2020.
Commenting ahead of the print, Bloomberg said that
"a slowdown in the first quarter will prove temporary, a consequence of omicron and the drag from volatile inventories and trade."
Maybe, but what if it's not temporary, like inflation was supposed to be according to the Federal Reserve who espoused that nonsense for close to 14 months as Inflation only kept getting worse. Maybe more importantly just how big of a slowdown might we see?
We have been told by the BEA that the Q1 estimate for the US economy unexpectedly shrank by 1.4%, the first decline since the Covid summer of 2020. Annualized GDP plunged from 6.9% growth in Q4 to an unexpected -1.43% shrinkage in Q1.
According to the BEA, the first quarter decrease in real GDP reflected decreases in inventory investment, exports, federal government spending, and state and local government spending, while imports, which are a subtraction in the calculation of GDP, increased. Consumer spending, business investment and housing investment increased
The US trade balance with the rest of the world collapsed to its largest deficit ever in March.
- Imports rose 10.3% in March to $351.52b from $318.62b in Feb.
- Exports rose 5.6% in March to $241.72b from $228.82b in Feb.
The gap in goods and services trade grew 22.3% to $109.8 billion, Commerce Department data showed. This was even worse than the median estimate in a Bloomberg survey of economists which called for a $107.1 billion deficit.
What we need to understand is that Net exports subtracted a whooping 3.2 percentage points from GDP.
What we need to not forget going forward is that the US GDP may marginally improve in Q2 because US exports are highly likely to be curtailed by Chinese Covid lockdowns and port closures. This could possibly give the US GDP a marginally positive but weak GDP print. Since a Recession is labeled as two consecutive quarters of negative growth, we could see negative GDP in Q3 and Q4 and therefore the recession wil be considered as starting in Q1 2023. This is what analysts are calling for but in economic reality and not academic jargon we will be effectively in a recession in 2022 with slow growth and high inflation.
This chart really depicts the reality properly! However, it may be too conservative!
According to Mohamed El-Erian at Allianz and one of the best market economists in the world, and I quote:
“The mess we’re seeing in the market is about liquidity!
I’m willing to put my neck out and say we have mostly priced in interest rate risk.
We haven’t priced liquidity risk, we haven’t priced credit risk, we haven’t priced market functioning risk.
We are still in the process of pricing it.
The days of abundant and predictable liquidity are gone.”
We won’t spend a lot of time on the warning indicators we are witnessed in the last couple of week, but we have seen:
- The Purchasing Managers Index (PMI) fall and is now approaching contraction levels,
- The US Productivity just posted the worst numbers since 1947 driving up labor costs,
- The Consumer Credit Numbers were shocking and showed everyone is maxing out their credit card – and this is before a looming recession?
Meanwhile the Personal Savings rate has also plummeted as disposable income is pressured by surging inflation in food, gas and consumer goods leaving no room for expanding demand consumption to overpower another Supply shock as occurred during the post Covid recovery.
What we also need to focus on is that we could already be in the midst of Stagflation but not yet be in a Recession. Though I believe a recession is a foregone conclusion it how monetary and fiscal policies address stagflation which will determine the depth of recession and its duration.
Frankly, I believe there are major concerns in both the area of monetary and fiscal policy, but we will leave that for another day.
The problem here is twofold;
- The Global stagflation concern,
- A Unique US Stagflation concern
Stagflation as you are no doubt aware is about having slowing economic growth in parallel with high inflation. It is a killer problem for policy planners and the public.
The stagflationary shock of 2022 is truly global, with diverging growth and inflation expectations across most countries with many different factors exacerbating the trend in a synchronized way.
Even without gas stoppages, growth in the eurozone slowed to just 0.2 per cent in the first quarter, while inflation rose to a record high of 7.5 per cent. “This will be a year of stagflation” in the eurozone, says Andrew Kenningham, chief Europe economist at Capital Economics. “Higher energy prices will keep inflation elevated, squeeze household incomes and dent business confidence.”
Germany is among the hardest hit, with its energy-intensive, large manufacturing sector and export-oriented economy. Over the past six months, economists have halved their 2022 economic growth forecast for Germany, while inflation expectations are three times higher.
The IMF recently downgraded their forecast for 143 economies this year — accounting for 86 percent of global gross domestic product.
“In economic terms, growth is down and inflation is up,” according to IMF’s managing director. “In human terms, people’s incomes are down and hardship is up.”
The consensus is now for global economic growth to average only 3.3 per cent this year, down from 4.1 that was expected in January, before the war.
Global inflation is forecast at 6.2 per cent, 2.25 percentage points higher than January’s forecast.
The US is experiencing stagflation with inflation at 40 year highs while GDP for Q1 has gone negative. US Inflation is higher than overall global inflation while GDP is comparable to Global GDP. But this is misleading.
I don’t want to cover what I laid out in last month’s LONGWave regarding Stagflation, but as a reminder the way to visualize what is occurring is to think of Stagflation as a potential Black Hole. It is easy to unwittingly and unsuspectingly get into but extremely if not impossible to get out of once trapped in it.
The secret is to avoid it with sound economic policies before you reach the “Event Horizon”!
Many knowledge money managers perceive we are potentially entering such a situation.
The reaction by central bankers and those on control of Monetary Policy is to apply traditional Keynesian thinking to the problem. But in this case it doesn’t work!
What must be done to control Inflation crushes growth.
What must be done to foster growth inflames Inflation!
It is the proverbial “Catch 22”.
The solution therefore is you must identify it early and act aggressively.
The hidden problem is that in the US the distortions, and reporting games we have been playing for a very long time, have let us get much too deep in the Black Hole than we understand because our measures have failed to alert us of the reality of the situation.
The political “Kick-the-Can-Down-the-Road” policy approaches have only fostered “tweaking” the warning measures to buy time and make it someone else’s problem!
Let me be specific.
Inflation through statistical distortions such as Hedonics, Substitution, Imputation and other methods which I have previously chronicled have distorted Inflation as measured by the CPI to such a degree that Inflation, Inflation Breakevens and Real Rates are ineffective measures.
I most recently laid out how the new world of Inflation Swaps has exploded in an attempt to protect the more sophisticated institutional investors from these mirrors and mirages.
Economic Growth is also seriously distorted by an obsolete formula that is based on sound money and adopted during the era of the gold standard and fails miserably to adequately describe real growth in an era of massive government debt, transfer payments and debt financed consumption now being nearly 70% of the economy. The creators of the simple formula never imagined an economy like the one we operate in today.
What does all this tell us about the market and future stock prices?
Slowing Economic GDP growth when markets are highly elevated relative to GDP is not a good sign for future stock prices!
Earnings can be expected to weaken placing downward pressures on stock prices and PE ratios. But there is more to that PE ratio than just current earnings.
PE ratio’s also move on Inflation. That is because Earnings are about future “Discounted Cashflows” (DCF). The key words here are:
- “Discounted” and
- “Cash Flows”
… and a hidden word called FREE.
DCF is a calculation of a company's current and future available cash, designated as FREE cash flow, determined as operating profit, depreciation, and amortization, minus capital and operational expenses and taxes.
Discounted Free cash flow is the metric used by investors to determine the future value of an investment based on its future cash flows. For example, if an investor buys a stock today, in 10 years, they hope it will sell for more than what it is worth today.
With Inflation exploding PE should be expected to fall or compress.
Consider the problem:
A PE of 12 is expected earnings of 8.33%
A PE of 30 is expected earnings of 3.33%
The higher the PE the poorer the earnings expectations
Earnings are expected to expand at exponential rates
- This comes into question when economies are expected to slow,
- When Inflation increases significantly (DCF),
- When Interest on company debt rises
WE HAVE ALL THREE!
PE’S CAN BE EXPECTED TO COMPRESS IN 2022.
Now we get to the real problem. It isn’t just that PE’s can be expected to compress from high valuations levels relative to economic growth , rising inflation and rising interest rates but that the market has risen through the domination of 8 key stocks.
These stocks over the last few years have dominated the stock indexes and a large percentage of ETF offerings.
I will refer to them as simply the FAANGS.
They consist of:
This year end chart illustrates the fundamentals of the Top 25 SPX companies. Note the PE ratios highlighted by the red box.
They average 53.3 and with their PE’s already down 45%.
With last week’s disappointing earnings the 8 FAANG stocks were down with their PE’s now:
Facebook 16.9 May 6th, 2022
Apple 27.0 May 6th. 2022
Amazon 58.9 May 6th. 2022
Netflix 18.5 May 6th, 2022
Goggle 20.9 May 6th, 2022
Tesla 123.4 May 4th, 2022
Microsoft 37.6 May6th, 2022
Nvidia 51.3 May 6th, 2022
The PE of the S&P 500 is now approximately 16.0
It is valuable to look at each of the 8 FAANGS individually to see what we can learn.
I will start with Apple where I breakdown there lift we saw since the 2008 Financial Crisis or what I will call the Pre-Covid lift which was about the new era of Quantitative easing or QE.
I separate this from the lift we saw since the spring of 2020 when trillions of dollars were again pumped into the economies around the world. Approximately $29T in total.
- We see Apple had gone almost parabolic as shown by the black dotted line,
- We also see Apple followed the an upper Bomar Band which has recently “curled” at the top,
- Clearly the biggest part of Apple’s increase in value has appeared during the Covid rally.
- We also see that momentum has shown in the lower pane has begun to deteriorate.
Moving to Microsoft we see a similar parabolic lift mostly as a result of the Covid rally.
- Microsoft has experienced slightly more weakness in Q1 than Apple,
- Its Parabolic lift has also “curled”
- But price has not yet fallen to the Bomar band mean.
- Momentum at the bottom continued to weaken but may have found some temporary support.
Moving to Google we again see a similar parabolic lift mostly as a result of the Covid rally.
Google has had:
- More of a drop during the first quarter of 2022 and has dropped to the center line of its Bomar Band,
- Again momentum at the bottom has deteriorated.
Tesla hasn’t been around that long that long but clearly almost all its gains have come during the Covid rally.
- Tesla has went parabolic but its upper Bomar Band which it tightly followed has curled,
- Tesla’s price like the others has fallen off in first quarter while experiencing significant volatility as it is the darling of the Gamma options players and has had significant influence on both Big 8 and the market overall,
- Its momentum is deteriorating quite significantly.
Nvidia exploded during the Covid rally and actually went parabolic before falling off quite hard.
- Nvidia has dropped to its Bomar Band mean,
- Momentum is down but may have found support.
Amazon exhibits similar characteristics as the other but note that its price has fallen to touching its lower Bomar Band and in fact has broken through it.
With Momentum falling it appears Amazon wants to give up all its Covid rally gains.
Facebook has had a bad quarter with disappointing earnings and guidance.
As such Facebook has fallen to its lower Bomar Band and momentum has left the stock.
Netflix was one of the major Q1 earnings news stories. It anticipates losing 2m subscribers in Q2 and as a result the stock was taken out behind the wood shed for a real beating!
Netflix gave up all of its’ Covid rally and then some. It broke through a Fibonacci 61.8% retracement of all its gains going back to the Financial Crisis lows.
When we consolidated the 8 stocks together the consolidated chart looks like this.
- The parabolic lift has topped and the upper Bomar Band has rolled curled,
- We are now below the mean.
It would appear we are headed towards the rising lower Bomar Band and a significant correction of all the gains of the Covid rally.
The same Big 8 stocks looked at differently shows a fairly orderly decline within the indicated channel.
I highlight here that the 20 WMA in red is about to cross the 80 WMA after having already crossed below the 40 WMA.
A cross of the 20 WMA of the black 80 WMA is likely to trigger a break of the channel to the downside.
To put this all in perspective this chart goes back to the late 70’s. What stand out are the long term red channel and the black channel since the 2008 Financial Crisis.
A test of the Covid lows only takes us to the approximately the bottom of the black channel.
It is our view that we will eventually touch the bottom of the red channel and the Big 8 will be major casualties of this drop. The PE’s will have experienced significant compression.
In the 1970’s when we last saw Inflation comparable to what we are witnessing today we witnessed PE’s compress from 15 to 8.0 or by approximately 50%
If the Big 8 FAANGS compressed by 50% to 22 they would still be well above historical standards of somewhere between 15-20.
Presently the longer term adjusted PE called CAPE is hovering near 29x, which is substantially above its long-term average of about 15x or twice as high. A 50% compression would bring it closer in line with its historical average.
It is important to understand that the equity markets have not experience what long term traders know to be called “Capitulation”. This is when people phone their brokers, no longer being able to stand further losses and tell their broker to get them out of the market.
This will happen once again but can be expected to be slightly different.
Normally this is triggered by excess Margin and margin calls occurring.
We clearly have historic use of margins but this has been falling without “capitulations”
If you look at the bottom pane you can see Margin has been hit pretty hard but still has potentially further to go. So the damage as yet has not fully happened.
The real problem is that the markets have significantly shifted since the 2008 Financial Crisis with the adoption of passive Investing through Exchange Trade Funds or ETFs.
ETF’ are quite structured in what they will hold and in many cases track well followed indexes, sectors or investment themes.
As a consequence real selling comes with what is referred to as “Redemptions”.
This is when a holder exits and wants their money back.
Today to get that money it takes a simple key stroke to sell an ETF online from your brokerage. This would force the liquidation of a large set of stocks held within the ETF to be sold. If only a few million people start hitting the sell key at the same time the liquidity (or lack of it) would literally implode the ETF and equity markets. This concern is well documented.
Redemptions are only now beginning to happen.
This will trigger “Capitulation” and a whole generation of investors will learn lessons other learned during the Dotcom and Financial Crisis crash. Liquidity to sell a stock can disappear faster than a thief in the night.
What might we learn from all this?
We are at one of the longest Business Cycles in history and a Recession is likely which will further compound the problem of Stagflation.
Stagflation means higher inflation and Slower Growth.
Both have a profound impact of PE Compression. PE’s are relative not just to earnings but the perception of growth and inflation. Both are changing in ways not seen since the last Financial Crisis.
The Fed is on course to raise rates and reduce its balance sheet. This will remove the pillar that has been artificially driving the markets since the last Financial Crisis and can only hurt stocks.
As I always remind you in these videos, remember politicians and Central Banks will print the money to solve any and all problems, until such time as no one will take the money or it is of no value.
That day is still in the future so take advantage of the opportunities as they currently exist.
Investing is always easier when you know with relative certainty how the powers to be will react. Your chances of success go up dramatically.
The powers to be are now effectively trapped by policies of fiat currencies, unsound money, political polarization and global policy paralysis.
I would like take a moment as a reminder
DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are for educational and discussions purposes ONLY.
As negative as these comments often are, there has seldom been a better time for investing. However, it requires careful analysis and not following what have traditionally been the true and tried approaches.
Do your reading and make sure you have a knowledgeable and well informed financial advisor.
So until we talk again, may 2022 turn out to be an outstanding investment year for you and your family.
Thank you for listening