Plenty to digest over the past few days, mostly positive from a market standpoint. First and foremost, the Fed meeting came and went without any real fireworks, which is certainly a good thing. As we discussed a few weeks ago, Chairman Powell’s testimony in D.C. laid a clear path which markets can follow. Small, 25bps incremental increases for now, are coming unless the data changes dramatically. Russian invasion into Ukraine caused more dislocation for oil and commodity markets than anyone could have forecasted a few months ago, but the Fed does not want to alter the economic landscape aggressively.
Inflation will peak soon and there are plenty of signs pointing to a global economic slowdown regardless. Interest rates have already risen. Loans are starting to cost more and are tougher to obtain. Manufacturing indexes are dropping. Backlogs are decreasing. Goods are making their way to shelves, helping on the pricing front. Ports are almost back to normal. Used car prices show monthly declines after jumping 40% last year. Oil prices spiked during the invasion but pulled back over 20% in 3 days on signs of incrementally positive negotiations. Froth has come out of equities, especially the high flyers. Consumers are pessimistic, which always foreshadows a slowing in spending. From my perch, slow and steady makes sense here.
Realistically, the market has already done the Fed’s job for them. 2-year Treasuries, which are a better barometer for funding costs, have spiked to nearly 2% from practically zero. The market is pricing in 7 rate hikes before they even happen. None of us borrow at the Fed window. We pay real market rates. In that sense, tightened monetary conditions are already here. Fed “reactions” are just that, and too late to the party. Going slow helps some financial institutions deal with rising Fed funds where they operate. 40 of the past 53 rate hikes have been 25bps. The Fed is almost always going to take the slow, easy way out. End result, they are cognizant of the inflation fears and will do what it takes. Seven rate hikes are priced in, conditions are tightening, and a rolling off of the balance sheet is next and will be well received initially. The Fed also has time to wait for data to change in either direction. This all takes a big question mark out of the fundamental story, at least somewhat.
Next up was a surprise action by the Chinese Government. For the past two years, they have been hammering their mega-cap technology leaders as they became bloated in size. China operates in a much different world than democratic nations. Companies were becoming too powerful and crackdowns were levied. Their economy has been shellacked by Zero-Covid policies and an all-out battle with successful companies. For instance, the Amazon of China, Alibaba, has seen their stock fall nearly 80% since “wealth distribution” measures were installed. China’s largest technology equity benchmark was down ~30% this year already. Fast forward to this week and President Xi finally reversed course. He offered assurance that markets will be supported, which includes foreign IPO’s. Alibaba jumped 30% in one trading session. This momentum continued across the globe, helping the Nasdaq recover 7% in just 2 days as well.
Another added positive was a few minor earnings updates from the tech sector over the past few days. Demand has been robust, showing no signs of slowing down. Companies identified Russia and Ukraine as risks should this skirmish drag on, but secular demand is alive and well. Remember, stocks don’t peak until earnings do. Any good news here will help support a market where nearly half of all stocks have already declined by 20% or more. Bad news is getting priced in.
Lastly, from a technical standpoint, investors are almost universally bearish. The last time investment advisors were more bearish was in April of 2020, near the exact low. Historically, investing when there is panic proves to be a smart move. On top of this, the S&P 500 has tested, on multiple occasions, the 4100 level and held. Although Covid and the Great Financial Crisis ended with spike lows, oftentimes market bottoms are a time consuming, base building affair. Sectors take their turn making lows, while major averages remain range-bound. This is shaping up to be one of those long, drawn out bottoming processes. In this type of market, one should not get more bearish on big down days or uber bullish on strong up days.
Selling companies which may have lost their leadership positions during rallies, and putting that cash back to work in new industry leaders during declines, is a prudent approach. Not all stocks will bottom together, and not all stocks are worthy of taking the plunge to purchase right now
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One of the most frequent questions we are asked as investment advisors is how we know when the bottom occurs. The simple answer is that no one really knows until months after the fact. However, you can use risk/reward tools to find favorable entry points. For Tower Bridge that means a few things must happen:
1. Understand the macro environment with respect to GDP, interest rates, regulations, valuations and economic trends.
2. Identify industries where growth rates are 2X+ that of GDP over the long-term (green energy, 5G, IoT, cloud, alternative foods, disruptors, digitization of everything, etc.).
3. Identify leaders in those specific industries.
4. Deep dives into leaders with respect to fundamentals, positioning in markets, pricing power, competitors, margin expansion, leadership, etc.
5. Most importantly, determine what the fair value is for each company.
6. Lastly, purchase said leaders on a 10% – 15% discount to our fair value targets.
The last piece is critical, especially during market corrections. No investor can time the market on a consistent basis. Some of the largest returns are during rebounds in corrective phases. History has shown that even the greatest investors don’t know where tops or bottoms start. If you can purchase world class operators with a solid track record, growing faster than the market and trading at a discount to historic norms, you should be rewarded over time. For us, it is not the next 3 days, weeks or months that matter, but the next 3-5 years.
To that end, there are a lot more stocks trading below “fair value” today than there were back in November. A lot of bad news has been priced in. Some still have more room to fall, but nibbling at favored areas where long-term values present themselves should prove fruitful. That being said, the moment that recessionary indicators like interest rates go from flashing yellow to bright red, capital preservation is paramount. For now, the yield curve is still positively sloped. If that changes, it is time to reevaluate bullet point #1.
Adam Levine is 43 today and Queen Latifah (not a real queen but a Globe winning actress) is now 52.
James Vogt, 610-260-2214