Financial Conditions Tighten

• Long term opportunities are driven by earnings growth therefore this is a good time to put longer term capital to work
• Equities aren’t outright cheap compared to long term return potential, but the gap is narrowing
• Earnings growth is decelerating but positive
• Earning expectations are good – which bring up concerns around potential recession. However, when discussing or analysis recession risk, remember the other side of the recession could generate meaningful returns
• Second quarter growth is not expected to be that hot, in the 3-5% range. In order to meet some of these earnings estimates we will need a strong back half of the year
• Recession could chop 15% off earnings
• Return potential is not at historical levels but has improved meaningfully
• Good tool is dollar cost averaging – allows you to find the way down the path regardless of recession risk

Financial Conditions Index

• This is a function of: Interest rates, credit spreads and equities prices
• When equity prices go down or spreads widen that adds financial stress which tamps down demand which is one of the main engines for getting inflation under control
• We’ve seen a fairly dramatic change in Stress Index
• If equities rally and inflation expectations don’t moderate further financial stress will reduce, and if the Feds are worried about inflation this is not something they want in the near term. Meaning if markets rally without inflation coming down means the Fed has more work to do

Inflation

• Peak inflation (right now or within the next moth)
• Components of inflation are starting to come off which is good
• Price of oil & employment cost index – two big factors that affect inflation
• We’ve seen a small deterioration on employment front
• Compared to other commodities have plateaued or rolled over, however the price of oil has not yet (at these prices we are certain to have demand destruction)

Valuation by Sector

• Although headline indices have declined, there is variation in the performance of the underlying stocks
• Areas that are overvalued include staples, utilities, commodities and industrials
• In this environment of volatility liquidity is becoming harder to source, therefore a couple things will take place: changes cost of capital (some free cash flow will be forced to go towards share buyback rather than what it was intended for), accelerate M&A in industries with overcapacity
• Areas in the market Stu is interested in: focus on early cycle businesses ( ex. Financials)

How do you prepare for different scenarios (rates rising and potential recession risk)?

• Stu has 3 scenarios he is preparing the most for:
  • Recession (make adjustment to revenue and the margin that the business will earn on less revenue and then make valuation based on those earnings and compare that to today’s share price. Also think about rebound valuation – might bounce higher on the return to normal)
  • Rising interest rates (Look at balanced sheet and find out how much leverage there is and if rates rise how much cash flow will be taken from me?)
  • Changes in secular growth (look at long term growth trajectory – look at IRR calculation, very valuable tool to use on tech businesses)