YWR: The Smell of Consensus

Disclosure: Personal views only. These are not investment recommendations.

What does everybody know?

• Everybody knows inflation is too high and the Fed is going to raise rates to 3-4% to try and get it back closer to 2-3%. The Fed dot plots tells us this is what they are going to do.

• Everybody knows that for the last 13 years Central Banks have been pressuring corporations, individuals and companies to borrow and take risk through sustained low interest rates. Low rates were meant to stimulate borrowing, which would kickstart demand and get us out of a deflationary trap. If you weren’t levering up you were missing out.

• Everybody knows that if the Fed raises rates to 3.5% it will slow the economy too much and cause a recession. It will be a repeat of the 2005-2007 or 2017-2018 rate hiking cycles. Bond markets are pricing rate increases through early 2023, quickly followed by rate cuts as the recession hits.

• Everybody knows that when the Fed is raising interest rates it is terrible for risk assets. The game plan is you stay in US$ cash or 10 year Treasuries and watch the Fed closely for any change in policy. Wait for the economy to tank, and the Fed to pivot; then you buy every hyper risk asset you can, EM debt, high yield credit, crypto, Tesla, etc.

  

• Everybody knows that even if sentiment is at record lows, the Fed still has 2-3 more rate hikes to go and it’s too early to be buying stocks/risk. If you are buying now you are a naive Millenial who never lived through 2008. The analogy is this is still June 2008. Things have sold off, but the real down move is still to come. Sentiment might seem low and stocks can bounce short-term, but these are just short covering rallies. Wait and see how this over leveraged world deals with a dose of higher interest rates. Wait and see what happens with multiple 50bp hikes. There hasn’t been any distressed selling yet. Investors are still complacent. It’s like we’ve had Northern Rock and Bear Stearns, but Lehman, Fannie and Freddie are still to come. This is what everybody knows.

This is what everyone knows, but it also has the strong smell of consensusness too it. Go back to the chart above. Sentiment is at 0.3. Yes, there have been times when it is this low and the market keeps going lower, and the main example is 2008, but there have been even more times where it is exactly correct, and you should be buying. There is always a reason it is hard to buy at these times. There is always a reason you say “Yes, sentiment is low, and I should but, but this time is different because XYX…”. I know. I’ve been there and I remember many of them. But usually, you are supposed to buy.

So I am going to brave the machine guns and paint an alternative reality for how this could play out positively for the market.

I had a good meeting this week with a friend in the mining business. We were discussing the rail strike in the UK and the 7% pay increase the unions are asking for. I was commenting that when wages start growing at 7%, that’s when inflation stops becoming transitory. If the biggest union in the country is getting +7% it’s a public signal we should all be getting +7%. My friend said if he was the head of the rail network he would agree to 7% and also ask the unions how many years they wanted to lock in the 7% pay increases, and the more years the better. Would you like +7%/year for the next 3 years? Yes? Done. Done because inflation is going to 15% and locking in your workforce at +7%/ year for 3-5 years will look brilliant in hindsight. His view is we aren’t a peak inflation, we are at trough inflation. Wow! So what if 7% inflation is the new norm for not quarters but years?

The consensus view is inflation is bad for the stock market. Corporate profitability is going to get hit and stock market P/E ratios are going to drop. P/E ratios have been high because interest rates were low, and so if rates go up, bonds become more attractive, the cost of capital is higher, and stock market P/E’s will drop.

But maybe the opposite happens and P/E’s go higher. I’ve been reading an amazing book on the history of statistics, probability theory and risk management called ‘Against the Gods’ by Peter Bernstein. I say amazing, because I don’t know how one person can know so much about the history of mathematics with so many anecdotes about the mathematicians and their personal lives. I’d love to meet Peter Bernstein.

In Against the Gods Bernstein discusses reversion to the mean strategies and how these strategies will work for years and then the underlying relationships can completely change. In the period after the Great Recession from the late 1930’s until the 1950’s it was the rule of thumb that stocks should yield more than bonds. The conventional wisdom was that stock dividends are more risky than bond coupons, so you should get paid more. If the market rallied and dividend yields got close to bond yields, the stocks sold off, because who would own a stock with a dividend yield lower than a bond yield? This was an established market pattern and strategists always referred to the attractiveness of stocks in terms of how much more they yielded than bonds.

Then in the 1950’s this relationship flipped. Up until this point from 1800 to 1940 inflation had averaged 0.2%/year. Then from 1941 to 1959 the economic backdrop changed and inflation increased to 4% a year. Treasury bonds issued in 1945 with a 2.5% yield declined to $820 from $1000. Meanwhile, stock dividends tripled between 1945 and 1959. With this the thinking switched. Stocks were no longer risky assets that should trade at a discount to bonds, they were high growth inflation hedged income streams that should trade a premium to bonds, ie stock dividend yields should be LOWER than bond yields because when inflation is high they grow. Bernstein says it took many years for the old school investors to accept this changing relationship and they kept expecting stocks to sell-off and go back to yielding more than bonds (pg 184). I bring this up, because it could be a template for today.

What if my friend is right, and inflation is not peak, but going to stay high for years? Then don’t you want to own stocks? Doesn’t that mean earnings are going to grow substantially in nominal terms? Isn’t it like Bernstein’s example of 1945 to 1959 where instead of crashing, stock dividends grow even higher? And maybe stock P/E multiples, don’t contract they expand. I know it’s Zimbabwe, but that’s exactly what happened there. When hyperinflation kicked in company P/E’s expanded from 5x to 30x. As inflation increases the P/E starts to not mean as much. Earnings are growing quickly and money is coming into the market as a hedge.

Notice that despite the sell-off in stocks and extreme bearishness, the S&P 500 EPS continues to grow. The push back is that analysts don’t see the recession coming and so these EPS estimates are backward looking. Soon the EPS will crash. OK, but it also fits the alternative case where higher inflation means higher earnings.

Source: Factset

Source: Factset

Then there is valuation. It’s come down a lot to 16x, and the bears will say it isn’t low enough. It needs to get to 14x. OK, but what if the valuation paradigm is changing and in an inflationary environment investors should pay more for stocks, not less? Then maybe now is a good entry point.

Source: Factset

Then going back to the sentiment indicators there are a few more interesting points from Goldman that increasingly make you wonder if maybe we are getting too bearish. Non-dealer positioning in S&P futures is at low levels. Generally, markets have a hard time crashing when everyone is short futures.

Then just interesting to see hedge fund shorting is at high levels. Hedge funds always over hedge at the lows.

And those corporates who don’t realize there is about to be a recession keep buying back even more shares. In fact 2022 share buyback authorisations are at record levels.

Source: Goldman Sachs

One final anecdote. I remember I was at HSBC, and I think the year was 2011. I took the CEO of HSBC’s Hong Kong business down to Newport Beach to meet some senior people at PIMCO. They wanted to hear what HSBC’s HK business was seeing in terms of lending and economic growth in Asia. The CEO said everything in HK looked quite healthy, then asked the PIMCO team about their views. The PIMCO team assured us that actually we were about to go into a recession and then called their top economist into the room to confirm that this was the view. Yes, picked up the phone, called the guy and told him to get down here right away so we could hear about the recession. We then had a talk from 3 PIMCO economists on the upcoming slowdown. The HSBC HK CEO said he didn’t see any slowdown in his business, but PIMCO assured him a slowdown was coming, and how do you argue with PIMCO? The S&P had been weak in 2011, the chart looked bad, and everyone was worried that after the strong bounce from 2009-2011, the market might sell off again in 2012. As further reinforcement of these fears on the plane ride back from LA to SF I was sitting behind two people also talking about the imminent recession. One of them said he would be OK because he at least spoke Chinese and would be able to get a job in China. It’s weird that I still remember that conversation on Southwest Airlines 10 years later, but I don’t remember the Great Recession of 2012, do you? Possibly, it will be the same with the Great Recession of 2023. When consensus is this negative, we need to force ourselves to think differently.

An Economics Paper Weekend

Last weekend was fun, but this weekend I need to complete a final paper for my economics course. Who knows maybe it won’t be as painful as I fear.

Have a good weekend for me!

Erik