Monthly Partner Memo – July 2022

June 29, 2022 | Paul Chapman


Take comfort in the knowledge that your capital is being managed the way your friends complain they wish theirs was managed.

“It's in the nature of stock markets to go way down from time to time. There's no system to avoid bad markets. You can't do it unless you try to time the market, which is a seriously dumb thing to do. Conservative investing with steady savings without expecting miracles is the way to go.” – Legendary Investor Charlie Munger

Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities.

Friends & Partners,

Assets everywhere continue to be ‘repriced’, and it’s amazing to watch the pendulum swing from exuberance for many assets (housing, growth stocks, etc) to fear. US markets officially hit bear market territory in June (down 20% from peak), and Canadian markets finally started to play catch-up on the down side. Don’t conflate this with a complete end-game for investing however.

Charlie Munger’s quote at the top of this month’s note is relevant, and Brookfield’s CEO has similar sentiment in saying “Don’t ever get yourself in trouble where you have to sell something at an inopportune time, keep investing during all periods of time, and you’ll do very well over the longer term. That’s what business is about. The rest of this stuff is just market gyrations that confuses most people.”

The central banks are certainly in a pickle now as they raise rates – it is clear they are ‘behind the curve’ on beating inflation, so they need to raise interest rates quickly to try and slow inflation. But raising rates puts further headwinds on an economy that is clearly slowing. The theory goes that higher interest rates will reduce liquidity and cause businesses and consumers to reduce demand for goods and services. Prices will then fall. This affects higher leveraged sectors the most, which are stocks and housing – stock prices fall (as we’re seeing), as will housing prices (as we’re also seeing). As for housing, higher mortgage rates are already pinching demand. One calculation I saw noted that the increase since January from 3% mortgage rates to over 6% now in the US means that 18mm fewer households can qualify for a $400,000 mortgage. That’s a 40% reduction in potential demand! That’s why your house is worth less now…

During good times, it feels like nothing can go wrong, and the current environment and trends will last forever. During tougher times, the calls for significantly lower markets and recessions hit a feverish pitch – this is where we are currently. But a recession is looking more and more likely as economic indicators are slowing for the most part. The question is when, and how deep will it be if we see one? Remember that the markets discount the future outlook back to today, so will be seeing a recovery past any recession once it becomes clear that we’re heading into one, so it will be sure to confound many pundits as it rallies into the abyss (remember spring/summer 2020??).

Let me be clear – this is not a 2008 crisis. And we won’t see 1970’s inflation. Things are slowing, and markets are difficult, but don’t expect a total financial implosion. Today, we have coordinated global central bank tightening that raises recession risk no question, but few signs of an impending financial collapse. Perhaps the crypto and meme stock speculation craze channeled many of the excesses into non-systematically important parts of the economy. These things are not going to bring down any economies; remember that crypto has largely existed in an offshore and unregulated market.

Valuation multiples have clearly come down in the stock market, but earnings outlooks have remained quite optimistic and have only just started to adjust downward (these two things drive overall stock values). If we do see a materially slowing economy, earnings estimates may be the last shoe to drop and need to come down more from here. What do forward EPS (earnings per share) contractions look like both in the absence of a recession and during a recession? During non-recessionary times, the median EPS contraction is usually ~5%. During recessions, EPS contractions ramp up to 14%. Such a decline would take the 2023 S&P500 EPS consensus of $239/share today down to ~$210, and if we combine a 15x ‘trough’ multiple on this implies an S&P level closer to 3,100. That is still 20% lower from here ‘worst case’.

It’s too soon to call a definitive bottom, though there are some encouraging signs to be aware of. Sentiment remains very negative, which is usually a positive counter-indicator – the BofA Bull & Bear indicator is at zero, and Marketwatch reported that this index last reached 0 only on a handful of occasions: August 2002, July 2008, September 2011, September 2015, January 2016 and March 2020. These were all major market low points. Many technical indicators are at levels only seen during major lows, and company insiders are buying at a rapid clip as of late. If we do, in fact avoid a recession, we have potentially seen the lows. Bear markets not coinciding with a recession tend to be shorter and less severe than those that do, with US stocks typically bottoming not long after reaching the 20% decline mark.

I’ve called and prepared for heightened volatility since late 2021, and that remains the case for now. I believe that we’re potentially going to get an opportunity that we only see every decade or so. Technical and valuation conditions are consistent with past major panic lows, but the key risk is a lack of earnings downgrades in the face of growing recession risk. Many economic forecast scenarios call for a slowdown to begin in Q1 or Q2 of 2023 (or earlier). Historically, recessions last about six months. As markets look forward ~6–12 months, and the stock market peaked in January, this puts the timing end of the bear market between now and late Q3, so we may be getting close…

Upcoming Event in Collingwood on July 5th:

I am honoured to be able to host BNN’s Andrew McCreath in person in Collingwood on July 5th which should prove to be an excellent event. Given the current economic and market environment, it is very timely that we are able to host Andrew for a market and economic update/outlook. Andrew is one of Canada’s leading investment minds, host of BNN’s “Weekly with Andrew McCreath”, and also is founder and CEO of Forge First Asset Management. Forge First is an alternative asset manager that manages over $1bn of assets and specializes in capital preservation strategies, and has been able to deliver positive returns this year where most asset classes are experiencing significant declines. I would love to see you there, REGISTER HERE

Earnings Outlooks Are the Big Risk Currently*

Earnings projections in Canada and the US have increased this year until recently, and may have a difficult time meeting current expectations of 15+% growth for 2022 if we see an economic slowdown which appears inevitable. Earnings may have a difficult time growing given:

  • ~60% increase in energy cost in 2022
  • ~125% increase in financing costs (interest) in 2022
  • ~5% increase in hourly labor costs over the past 12 months
  • ~16% increase in the US dollar value over the past 12 months.

Given the pullback in the markets we’ve seen this year have largely been driven by valuation multiples compressing and not earnings (yet), this could be the main driver of further weakness in equities moving forward and is the number one risk to contend with and monitor at the moment.

It’s Ugly, But This is Not 1970’s-Style Inflation*

There are a number of reasons that I don’t believe we’ll see inflation like we did in the 1970’s. Inflation at that time got kicked off by the collapse of the Bretton Woods system and the separation of the US dollar from its last link to gold. Remember that since the end of WWII, America was essentially on a ‘gold standard’. Politics shifted left by the 70’s, and President Nixon opted to delink from gold, which delinked the world’s monetary system to that gold anchor, and the USD depreciated quickly setting off inflation.

Also remember that globalization wasn’t around yet, and national economies were also essentially closed in the 1970s. Imports were a tiny percentage of GDP (just over 3% for the US). Today’s world is hyper-connected. Many believe we’re on-shoring again which is true to a point, and is contributing to inflation no doubt as we won’t make as much stuff abroad anymore for cheap. But the reality is multinational business interests always find ways to circumvent government regulations and trade barriers, we can’t slow technological innovation and labour substitution will continue no question. Here’s proof: China’s foreign trade has actually continued to surge, with exports as a share of global GDP and global trade reaching all-time highs despite heavy tariffs imposed by the American government.

As well, we are now a more service-based economy as opposed to being so reliant on manufacturing years ago. During the 1970s, manufacturing was ~25% of the economy, whereas it under 10% today, so oil intensity is far lower. The US economy uses 70% less oil than 50 years ago to produce the same amount of national output! All of this means oil shocks are far less inflationary.

Finally, productivity is much higher today. Unions are 10% of the workforce in the US, well under half of what it was in the 70’s. Wage controls in the 70’s fueled inflation then, and productivity growth collapsed. Productivity today is on fire and has been for years. This lowers inflationary pressures of course.

Contrary to the consensus, expect lower inflation in the coming months. Inflation will trend also lower for reasons that have nothing to do with monetary tightening (i.e. the buildup of goods inventories and over-ordering, easing supply chain pressures and the tech rout reining in excesses). And, as I’ve noted before, we may even be talking about DEFLATION in the coming years after an economic slowdown given the 3 D’s (as David Rosenberg puts it) - debt, demographics, and disruptive technology, all of which didn’t get hurt by COVID and will reassert themselves in time.

Stay the Course? Really?*

Peter Lynch, perhaps the greatest fund manager of all time, advised: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Warren Buffett advised in his 1996 letter to Berkshire Hathaway shareholders: “Inactivity strikes us as intelligent behavior.” In his 1988 letter, he stated: “Our favorite holding period is forever.” And in his 1996 letter, he advised: “We continue to make more money when snoring than when active” and added that “our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.” And finally, he famously advised investors that if they could not avoid the temptation to time the market, at least they should “be fearful when others are greedy and greedy when others are fearful.” It has always seemed to me that the greatest anomaly in all of finance is that, while investors idolize these two legends, so many not only ignore their advice but tend to do the opposite.

Does this look alarmingly familiar by chance?


Source: Manulife

We have to remember that since 1950’s, U.S. equities have entered into a bear market every 7 years or so. With the benefit of hindsight, these moments often look like attractive times to put money to work, though never feel like that at the time. Bear markets are very ‘poorly behaved’ – they are not orderly, and are full of intermittent and face-ripping rallies as we’ve seen. While it can be tempting for investors to try to time an exit from a crappy market to avoid further declines, diligent investors have been rewarded for sticking around for the prevailing bull market periods. Predicting the near-term direction of markets is incredibly difficult.

Source: RBC GAM

I’d close this section by saying please don’t try to time the market – we can be tactical, and we are, but we don’t try to make binary calls, that will only get you hurt. If you exit the market completely, you likely crystalize losses and miss major moves, which often occur during weak markets like we’re experiencing.

How Close Are We To A Bottom?*

The current bear market selloff has been more severe than average:

Source: Goldman

In terms of valuations, US stocks are not necessarily “cheap”, but have become reasonably priced at their long-term average at a minimum. Small caps are definitely cheap, trading at multi-decade lows. Canada is also below its long term average so is arguably ‘cheap’. This valuation backdrop sets up an environment for further ‘value’ outperformance over ‘growth’, in my view, as lower P/E stocks typically outpace higher P/E stocks following periods of elevated market valuations:

How much of this is priced in and reflected in sentiment? Here is the US consumer sentiment index from the University of Michigan goes back to 1952, and it’s ugly (this is a bullish counter-indicator):

Friends Don’t Let Friends Buy Index Funds, Part V*

I’m sorry, I just can’t stop harping on this as I believe one can do much better than index hugging in this environment moving forward. Indexing may have worked for the last decade, but it isn’t working today and is unlikely to work for the next decade (sound familiar? A few things won’t remain the same!). 

BMO dug into the normalization process of earnings, and one of the main characteristics is a rise in growth dispersion across the market and various sectors. Following a broad earnings recovery in 2021, earnings growth dispersion dropped to cycle lows as most companies enjoyed a cyclical rebound in earnings. This is changing as they’re seeing a sharp rise in earnings growth dispersion among companies now, and expect this to continue. This means that we have entered a more differentiated fundamental environment that should favour a more selective (i.e. increased stock picking) investing approach. As well, like EPS growth profiles, valuation dispersion among companies has also significantly increased and is near peak levels, and despite this, intra-stock correlations have spiked recently! Something has gotta give. The market is being very ‘macro driven’ and expect it to become more selective as these trends continue.

The takeaways is there is still time to get ahead of this, get out of index funds and into well managed quality companies. Work with the best managers who can navigate and find these companies and management teams in every geographic region and strategy. This is where I can help.

See my prior points on this theme in ‘Friends Don’t Let Friends Buy Index Funds’, parts 1, 2, 3, and 4.