Jan. 1, 2023
Very Happy to put 2022 in the rear-view mirror…
Bear markets are always out there and while they are stressful and difficult, history shows that the opportunities they create are truly astounding. This one is no different, and it’s important to keep in mind that when we get to the other side of it the opportunities will be extraordinary. I don’t think we are quite there yet.
As Warren Buffett has famously said, “volatility is the friend of the long-term investor.”
2022 was one of the worst years ever in financial markets and Peattie Capital is no exception. Not just in equities, but supposedly “safe” assets like government bonds were down across the board, and the prototypical 60/40 (bonds/equities) portfolio lost nearly 20%. The Nasdaq, usually more volatile than the S&P 500 and the Dow Jones Industrials, dropped 33.1% while the other two were down 19.4% and 8.8% respectively. In addition, the iShares Core U.S. Reit ETF (“USRT”) was down 26.8%, and the U.S. Government 30-yr. bond was down 30%.
For the past several years most portfolios have been overweight growth and “change” as that is where I believed (and still believe) the best long-term opportunities are. In 2022 however, that was the worst possible place to be invested, as many names dropped 40%-50% and in some instances much more.
IRAs are more flexible and can be a helpful hedge
In most non-taxable portfolios I sold long-term winners and, client depending, used the cash for tactical positioning and trading. As a result, performance in IRAs was better than in taxable portfolios, and the best overall client accounts are those where I have both taxable and non taxable portfolios.
As we start 2023, I have maintained healthy cash balances in most IRA portfolios, in some cases as much as 65%. That said, I am looking for places to put that cash to work.
The Federal Reserve is still the driving force as we enter 2023
Chairman Powell used the term “2% inflation” repeatedly in his December 14 press conference which suggests to me he doesn’t anticipate a “pivot” anytime soon. Despite the fastest tightening cycle in history, annual inflation is still running over 7% and the Chairman has emphasized there is more work to do. Any number of commodity prices have come down, but growth in wages, food costs, and many services remains elevated.
Given his posture, and a variety of economic news and indicators, many people are calling for a recession in 2023. Mike Wilson, lead equity strategist at Morgan Stanley, recently warned of a further drop in the S&P 500 to the 3000-3200 area, down roughly 20% from today, as lower earnings are looming.
The unanswerable question as we enter 2023 is how the Chairman will respond if we do have a recession. At the slightest hint that he intends to ease off on the relentless tightening, regardless of when that might happen, I would expect markets to find their footing and rally, possibly quite strongly.
Earnings season will begin late January and I’m looking forward to hearing what companies have to say about their prospects in 2023. In the meantime, I expect to be cautious as we work our way through the tightening process. It is a most difficult time, but the best opportunities come from bear market selloffs.
A changing of the guard?
Microsoft (“MSFT”) and Alphabet (“GOOG”), two long term market leaders and prominent Peattie Capital holdings, were down 29% and 39% respectively and are good examples of why most Peattie Capital portfolios were down significantly for the year.
Having owned these two (and a couple others) for nearly 10 years I am reluctant to sell them as I think they are deeply entrenched in all our lives and still generate enormous free cash. Selling them would create both significant capital gains for a number of clients and also the issue of when/if to buy back in.
They are both expected to grow earnings next year mid/high teens and are currently valued at roughly 21x and 17x respectively. To my way of thinking these are reasonable multiples and for now I expect to keep these two in most taxable portfolios. However, they are not cheap and, in a recession, earnings for them, and nearly all companies, will be under pressure.
One other consideration for these two is that market leaders of one era tend to underperform in the next market upturn, whenever that may happen (think nifty fifty stocks in the 60’s, or Japan in the 80’s for example).
The S&P 500 is trading at roughly 17x 2023 earnings estimate of $220, and many companies in defensive industries like consumer staples are trading at far higher multiples and have little growth. For example, Colgate-Palmolive (“CL”), Coca-Cola (“KO”) and Procter and Gamble (“PG”) trade at 35x, 28x and 27x earnings respectively (source: Yahoo Finance). Among Peattie Capital portfolios are several names trading at much lower trailing earnings multiples: Thor Industries (“THOR”), and Arrow Electronics (“ARW”) are both below 5x and Sylvamo (“SLVM”) and Nelnet (“NNI”) are roughly 5x and 6x respectively.
Maybe a few silver linings
1) A reasonable alternative to equities is available in short term Treasury bills, which currently yield about 4.40%. I have been parking funds there in anticipation of better buying opportunities.
2) The vast majority of the tightening could be behind us. The bond market is very clearly signaling as much, as the U.S. yield curve is deeply inverted, which historically has been a reliable indicator of recession. Most analysts believe that rate hikes will end in the first half of 2023 and some think that the Fed might even have to begin easing shortly thereafter.
3) Excepting consumer staples companies, multiples, overall, have come down significantly. For example, some hyper growth software names have dropped from above 50x sales to roughly 10x sales. Notable to me is that these companies continue to grow at scale and are trading above their mid-year lows, and for more aggressive accounts I own several hyper growth software companies.
4) Late in the year the merger business picked up. In December alone, Thomas Bravo offered to buy Coupa Software (“COUP”) at 8x forward sales, and Vista Capital closed on the purchase of Avalara at 8.5x forward sales. Private equity firms have plenty of money, an incentive to spend it, and have a multi-year holding period. Likewise, large cap pharmaceuticals have oceans of cash and are looking for ways to replace revenues from drugs that will go off patent. Amgen Inc. (“AMGN”) just offered to buy Horizon Therapeutics (“HZNP”) at $116.50 per share, about 50% higher than the shares were trading in November.
5) Year-end tax loss selling has created some interesting opportunities. For example, when cannabis reform was excluded from the year-end omnibus bill, the industry’s ETF (“MSOS”) dropped from $14 to about $7 and ended 2022 down 73%. Meanwhile laws around cannabis continue to soften in many states. There are still any number of challenges and issues for the industry; however, for those with a longer-term investment horizon and the stomach to ride out the inevitable ups and downs, this might be a buying opportunity.
6) China is moving towards re-opening, and if that continues, I expect that to be good news for global growth.
Conclusion: Have we reached maximum fear?
Gold has rebounded sharply the past few months, and a Bank of America survey of portfolio managers revealed that they hold collectively as much cash as they’ve held since the 9/11 crisis in 2001. In addition, in December, the CBOE equity put/call ratio spiked above 2.0, which was higher than it went in either the tech bubble or the financial crisis, when it hit 1.8.
None of these data points by itself is enough to conclude that the worst is behind us, but in the past extreme fear indicators like these have been a better time to buy/own stocks rather than to sell them. While I do not think it’s time to jump in with both feet, I believe that it is important to stay invested in anticipation of better times ahead.
Please feel free to contact me with any questions or comments and best wishes to all for a healthy and happy new year.
