“You don’t have to run faster than the bear to get away. You just have to run faster than the guy next to you.” – Jim Butcher
Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities.
Friends & Partners,
We are through another year, and snowmaggedon over the Holidays. Santa may have arrived to many homes, but the hoped-for Santa rally in markets never materialized – caution proved warranted, and this remains the case for the most part today.
And as much as I wish I could say the end of 2022 will mark an end to this bear market, that may not be the case. The start of 2023 will likely not be easy for markets either, and I expect rocky seas to continue for a while yet. But we are getting closer to something very interesting - the lesson of history is clear: every time we have had to endure a period like we have seen over the last year or so in the markets it has ultimately yielded a generational opportunity to secure a financial future for clients.
Negativity abounds, and will eventually hit its crescendo, valuations will become compelling, and the light of a brighter economic dawn will shine through the storm clouds. That will all happen, and when it does we will have the best opportunity and set up in well over a decade. It takes time, but we are getting closer.
The opportunities won’t be where they were in the last bull market – boring will be back in. Leaders in one bull cycle are very rarely the leaders in the next. We often look for comfort in familiarity. Tech may not be your leader moving forward. Interestingly, the Big Tech cohort (AAPL, MSFT, GOOG, AMZN, TSLA, META, NVDA) has collectively shed ~$5 trillion of market cap during the course of 2022, which roughly matches the amount of value lost by the entire Nasdaq Composite back in the dotcom bubble.
Things have certainly been painful for many in 2022. The great Howard Marks puts it best in his recent memo: “Importantly, if you grant that the environment is and may continue to be very different from what it was over the last 13 years – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead.” I have noted that we’re experiencing a generational shift in markets, and will go as far as saying ‘it is different this time’ – which is really saying things are really no different, they are just back to a form of normal, which is a ‘normal’ that hasn’t been experienced in the markets for years.
We still remain defensively positioned and well-hedged, which has served us and our clients relatively well in 2022. We continue to nibble at a number of strategies and positions that are attractive opportunities given the weakness that the markets have experienced so far this year in both equities and credit. Remember, most of the money you make is not a result of trading. It is a result of waiting. You buy something, you wait, and you wait, and you eventually sell it. It’s not the best traders who are billionaires – it’s the best waiters.
There is no shortage of forecasts and outlooks for 2023, which often prove inaccurate naturally. As Benjamin Graham famously stated, “in the financial markets, hindsight is forever 20/20, but foresight is legally blind”. But if you want to really dig in here, here are the bulk of Wall Street outlooks for 2023:
RBC’s Outlook HERE
Morgan Stanley’s HERE
JP Morgan’s HERE
BlackRock’s HERE
Janus Henderson’s HERE
Charles Schwab’s HERE
Goldman Sachs HERE
Bank of America HERE
HSBC HERE
Barclays HERE
NatWest HERE
Citi HERE
UBS HERE
Credit Suisse HERE
BNP Paribas HERE
Deutsche Bank HERE
ING HERE
Apollo Global Management HERE
Wells Fargo HERE
BNY Mellon HERE
Fidelity International HERE
Lazard HERE
A Few Other Interesting Things to Highlight
It was a great night for Philanthropy in early December when the Georgian Triangle Humane Society hosted their Spirit & Sparkle Soiree. There were 100 people in attendance, and the evening raised almost $60,000 for the GTHS. This helped to make an impact on the daily essential services the GTHS offers to meet the overwhelming need of vulnerable pets and people that come into their care. I was proud and honoured to be the presenting sponsor.
My son Stanley enjoys solving Rubik’s Cubes, and now beating me at Chess once in a while… I am proud to be including in the list of distinguished supporters of the Second Annual Collingwood Chess Festival. This event’s organizers work 24/7 to make Collingwood the Chess Capital of Canada. You can see more info at https://collingwoodchessfestival.com/.
Finally, in concert with Women Worth and Wellness, we have a number of wonderful events in store for 2023, stay tuned for details. We will also partner again with the Collingwood General & Marine Hospital, as well as United Way Simcoe Muskoka and their Women United program to support those initiatives.
There’s a Positive Scenario for 2023 You Know*
As we enter the New Year, the key question for markets remains: Will inflation fall faster than economic growth and earnings?
If growth and earnings fall faster than inflation, this is the negative scenario. In this instance, we get a stagflationary recession. One of the reasons stocks have fallen in December is earnings concerns and growth concerns, and that relates directly to valuations. If consensus around 2023 earnings continue to fall to $210/share (from the current $225) for the S&P500, then even if we assume a constant multiple (16.5x) it means the “fair value” of the S&P 500 could drop around 10% from current levels (to under 3500). But in this scenario, growth also will be falling but because inflation is still high the Fed can’t pivot, that means the multiple will fall further, perhaps to ~15x, more common around a recession. That means that a “worst-case” scenario could be something like $210 2023 EPS X 15 multiple, which get under 3200 for the S&P500.
But, if inflation falls faster than growth and earnings, this is the positive scenario. Contrary to those arguing for “sticky” inflation figures, many metrics show it is falling like a rock. If that continues, we get a “soft landing”. Consider the above example. What if 2023 earnings stay at ~$225/share and growth slows, but only partially and inflation falls quickly. Then, the Fed can “pivot” (i.e. decrease rates) and the multiple on the market can move upward toward 17x-18x. That means “fair value” in the S&P 500 will be closer to 4,000.
The economy has remained more resilient than most expected, and there are some earnings tailwinds in the form of a falling US dollar, supply chain easing and aggressive corporate cost cutting. The outlook for the markets in 2023 is almost unanimously negative, which is notable – the market tends to prove consensus wrong. Yes, there are challenges ahead, but it’s not hopeless. We could well see a continued drop in inflation and/or earnings that are better than feared.
We have to remember that the market is a discounting mechanism, which means it looks ahead (remember the depths of COVID as the market rallied for example). It will move ahead of economic data. The market has a tendency to strengthen before economic conditions start to improve. As a matter of fact, in 1974 (similar environment to today in a number of ways), U.S. equities bottomed precisely when both interest rates and EPS peaked out, and this was followed by a sustained recovery in prices even though corporate earnings were falling into a recession. Why? When interest rates start to fall, investors tend to look beyond the immediate valley in earnings and to discount a better economy ahead.
The chart below exhibits this further. As you can see, often the equity market bottoms about 3-4 months before the bottom in GDP, with healthy returns being delivered during that time period. As the economy recovers, it often sets up the market for a new bull run. These on average last about 48 months, with strong gains occurring over that time frame for those who stuck around to experience the rally:
Source: RBC GAM
The market is expecting that the Federal Reserve in the US will soon signal that they may pause and even reverse course on interest rate hikes. Bonds have performed very well in this scenario historically, and stocks tend to do well too.
Finally, note that sentiment remains quite negative, though we may not have seen the final capitulation and ‘washout’ we tend to see when the ultimate lows are in. But we are getting there. We have seen equity mutual fund outflows 39 out of the past 40 weeks, and momentum on this front is picking up. Goldman Sachs notes that the current pace is rivaled only by Oct 2008 (financial crisis), Dec 2018 (trade wars + Fed hike into slowing economy leading to worst December since 1931), and Oct 2020 (Trump/Biden election).
Source: Goldman Sachs
So, amidst all this negativity out there, you may just be surprised to see where markets end up thru 2023…
Yet Challenges Certainly Remain…*
A recession is definitely becoming the consensus view amongst economists and market pundits. The number of respondents in the US SPF (Survey of Professional Forecasters) now foreseeing a recession in 2023 hit 44%, which is by far the highest percentage of respondents expecting negative GDP growth in over 50 years.
A slowdown is certainly in the cards, regardless of the depth of one that we will likely experience. The US Conference Board’s Top 10 Leading Indicators gauge has a track record in anticipating every recession since the early 1970s:
And this bodes ill for corporate profitability. Low growth, an increasingly challenged consumer and sticky inflation create an outlook that is challenging for margins. Inflation boosts revenue lines but can be tough on margins. The long-term graph below compares the forward 12-month expected percentage change in EPS for the S&P 500 (light blue line, left axis) against the Philadelphia Fed’s future nominal orders book (dark blue line, right axis), the latter being advanced five months to the former. The obvious fit between the two lines suggests that current estimates of $220 in EPS for next year are too optimistic, something I’ve been discussing in my monthly memos since late summer:
Do you think earnings hold up to where they’re currently projected to be for 2023 and 2024?
Source: JP Morgan
So, all this said, the conditions may not be in a place for a market bottom quite yet. This table from Morgan Stanley would certainly make this argument, as the conditions that need to be in place to mark a bottom of a recessionary bear market are not in place yet. This would require PMIs of well under 50 (we’re still around 50 today), an unemployment rate increase of 1.3% (we’re only up 0.2% today), and a forward earnings expectations drop of almost 11% (today’s forecasts are only calling for a 3.9% decline so far):
Source: Morgan Stanley