by Doug Kass, President, Seabreeze Partners Management
Let’s first consider:
- Does a mild and brief landing lie ahead?
- Have interest rates peaked?
- Will lower rates lead to a rally in large-cap growth stocks and for the market as a whole?
I am growing increasingly, and incrementally, more bullish on equities, in part based on my expectations of a mild and brief recession and a possible rapid deceleration in the rate of inflation, causing a less hawkish Fed.
I respect the difficulty of a soft landing.
However, some of the following conditions suggest a briefer and more mild economic downturn than is generally expected by the consensus:
- $2 trillion of excess consumer savings.
- A cushion of sizeable unrealized/imbedded gains in the nation’s housing stock.
- A strong industrial/corporate base that has generally improved their balance sheets by rolling over into inexpensive debt over the last five years, and has maintained high profit margins.
- A still robust and tight labor market — with solid wage increases a highlight of the last several years.
- As noted in this post, some important components of inflation are moderating — the prices of commodities have fallen considerably over the last 2 1/2 weeks.
- Interest rates may have peaked.
- Developing signposts that the supply chain disruptions are slowly behind resolved.
The confident optimism of 2021 has morphed into the unsteady fear and uncertainty of 2002.
Investor sentiment, as noted in my Bloomberg interview is sour and worsening, along with lower prices.
Hedge funds and retail investors have considerably de-risked and de-grossed.
Several high profile and formerly successful hedge funds have effectively folded under the pressure of poor performance and redemptions.
This happens at bottoms, not at tops!
Bank of America’s Bull/Bear Indicator hit zero last week.
The last few times this occurred was in August 2002, July 2008, September 2011, September 2015, January 2016, and March 2020.
The Pollyanna strategists of late 2021 have been converted to Cassandras in June 2022.
I am not dewy-eyed.
I am mindful of the difficulty in landing soft.
At a recent Ira Sohn Conference, my idol, Stan Druckenmiller understandably said:
“…once inflation is above 5%, it’s never been tamed without a recession. I
If you’re predicting a soft landing, you are going against decades of history. Could happen, anything is possible, but odds are stacked against you.”
But I do recognize the resilience shown by the consumer and by corporations over history.
I remain struck by the differences in perception and reality between late 2021, when there was a negative optionality of outcomes, compared to today, a possible positive optionality of outcomes.
Conditions Have Changed
Today conditions are quite different as the potential for the positive optionality of expected outcomes are expanding:
1. Stocks are no longer priced to perfection — valuations have retreated from 23x to 16x. Many good stocks have been rerated by 50% without a material change in fundamentals.
2. Speculation and froth have been rooted out of the markets — the declines in speculative stocks have been as deep as in any cycle that I can remember and that includes the dot.com era. As examples, Carvana (CVNA) has dropped from $376 to $25, Coinbase (COIN) has declined from $368 to $62, and Robinhood (HOOD) has fallen from $82 to $7.
3. Even the Perma Bulls have materially lowered their S&P price targets — some, like Ed Yardeni, have entirely thrown in the towel. The Bears’ S&P price targets are now 3,000 or lower.
4. Today bears are lionized. The Trojan priestess, Cassandra, has had a renaissance of popularity!
5. Interest rates have moved up dramatically and there is plenty of room for rates to retreat from here. Credit spreads have widened considerably.
6. Consensus earnings, economic and market expectations are being taken down and have become more realistic.
7. Inflationary expectations likely have peaked. Already commodities prices are turning lower. Soon the rate of gain in home prices will rapidly decelerate — and the decline in stock, bond and cryptocurrency prices — and “negative wealth effect” — have become non trivial headwinds towards reduced demand, likely also contributing to a slowdown in inflation.
8. Market positioning has turned conservative as investors have de-grossed and de-risked. As an example, Dan Loeb’s Third Point hedge fund was recently only 23% net long, compared to 71% at 2021 year-end.
9. Volatility is elevated — there is room for the VIX to decline if inflation moderates and we land more softly than the consensus expects.
10. The Federal Reserve has already begun to tighten and, given signposts of moderating inflation and slowing GDP, the neutral rate may be lower than is generally expected.
11. The Russia/Ukraine conflict continues apace — but, hopefully, is closer to ending than starting. And, also hopefully, the end of the lockdown in China could also be closer to being resolved.
I am mindful of the challenges of executing a soft economic landing.
Nonetheless, a mild and brief economic downturn remains my base case.
Gazing into the rear-view mirror is not the key to delivering superior investment returns — as markets are forward looking.
Consider, for example, how murky conditions were in early 2020 as Covid spread.
The market rally from that point – or uncertainty – in time was spectacular.
For the reasons mentioned in this missive, and others, I am a buyer of equities.
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