December Market Update 2022

Markets have been performing well over the last 6 weeks, with the S&P500 Index rising 13% since mid-October, and the Canadian markets TSX300 index up 11% over the same period. In light of these encouraging results, I thought it would be worth looking into the forces currently driving the markets and whether we can expect this trend to continue.

 

  To say that these are challenging times is an under-statement. Many veteran billionaire money managers such as Stanley Druckenmiller, Paul Tutor Jones, and Amazon founder Jeff Bezos, have been issuing warning messages about the markets for many months. Experts agree we are in a bear market and are likely to continue to be on one for some time. The affects of high inflation have forced the Fed and the Bank of Canada to aggressively raise rates at a pace not seen since the 1970s. The impact of these rate increases take 6 to 12 months to be fully seen in the economy. This means we will not know what impact these increases will have on the markets for several more quarters. Third quarter 2022 earnings for the S&P500 were mixed with lower earnings results for many companies, especially in the areas of consumer retail, cloud computing, PC sales, semiconductors, consumer lending and new mortgage loans. The common theme here is that just as supply chains are starting to open up and inventories are building, consumer demand is falling for PCs, gaming chips, and even data centres. Semiconductors are notorious for such swings as they are one of the most cyclical sectors within technology. They are all giving lower guidance for 2023 and are over-stocked with inventory. Expect this trend to continue in the fourth quarter and at an accelerated pace. Target, TJ Max and Walmart are running into similar problems.

 

  We are now seeing companies begin to lay off employees. Recently Amazon announced layoffs of 10,000 employees, META and Shopify announced layoffs, and Twitter just laid off half their staff, many other tech companies are doing the same, with many more to come both inside and outside the technology space. Consumer spending remains resilient but for how long? Credit card debt is all an all-time high in the US, but their spending habits may change once their credit runs out. The US and Canadian consumer makes up 2/3 of their economies, so as they go, so do the markets.

The housing market represents about 20% of the US and Canadian economies, and we are seeing significant declines in housing prices and sales activity. Most home owners have locked in their variable rate mortgages, converting to fixed rate mortgages over the last several years. US home owners will be reluctant to move if they have to refinance their new mortgage at rates currently over 6% and going higher. The Dallas FED said today to expect a 15% to 20% contraction in US housing prices next year.

 

  Money supply is shrinking globally. As the Fed raises rates they are also reducing their balance sheet, by about $80 billion each month. The US dollar is the currency in which almost all foreign trade is conducted, and is 60% of the world’s sovereign currency reserves. As supply shrinks, it tightens credit and reduces collateral available to facilitate trade. The US repo market went through a crisis in 2018 when the FED tightened money supply to that market, starving the over-night markets of capital to support bank lending and clearing activities. Credit spreads ballooned out, markets dropped as investors feared a run on the US banks. We are seeing similar early signs of this now, with the recent plunge in the value of the British currency and pension bonds values, when the recent government policy threatened to raise debt levels for tax cuts that were unfunded. This would not have happened if liquidity concerns were not elevated. Interest rate swap spreads are now yielding less than the rate of inflation, due to a lack of collateral and rising counter-party risk in the financial markets as lenders deal with a contraction of access to US dollars. Japan recently had to intervene to support their currency by buying Yen with their reserve currencies of US dollars; an indication of the level of stress in foreign exchange markets due to the flood of money buying US Treasuries as a safe haven, driving up the US dollar, as investors seek safe places to ride out the market uncertainty. These stresses will increase in the coming months and quarters as the FED continues to reduce money supply, with the potential for more unintended negative consequences for credit markets.

 

  Finally, the yield curve is not only inverted, but more inverted recently than at any time this year, with two year Treasuries yielding 4.43% vs the 10 year yielding 3.71%. Historically this is predictive of a recession in the next 12 months. Long rates tell you what long term inflation plus real growth will be in the US economy, and short rates tell you where the market thinks the FED is going in the short term with rates. When the cost of capital exceeds the long term growth rate, there is no incentive to invest new capital, and the economy slows.

 

  How will the markets react to these huge changes in the global economy? Currently the estimates for S&P500 earnings in 2023 are 5.2% higher than this year, which was an all-time record high of approx. $220 in 2022. How can we have a slowing economy and financial restraint, declining housing markets and consumer spending, and still have earnings next year go up 5.2%? Yet that is what is currently priced into the markets right now. That means we are trading at 19.5x next year earnings estimates which only works if you believe there will be no recession in 2023.

More likely we will have to see earnings estimates come down more, at least to the 2022 levels if you are an optimist, more likely a 10% decline to be more realistic, down 20% if you are more bearish. At $220 earnings for the S&P500 next year, so flat with 2022, which is optimistic, we are now trading at 20X earnings. If we see a moderate recession next year and earnings are down 10%, to $200, then we are trading at over 20X next year earnings. Historically, during recessions the market trades at 14x to 17x earnings. This means that if we have even a mild recession next year, valuations of stocks are about 15% too high. If we see earnings decline 20% next year, then valuations are 20% too high.

 

  So why are earnings estimates still so high for 2023? The reason is that analysts do not want to drop their estimates until they are told by the companies they follow that they expect lower results next year. So far, companies have been reluctant to give any guidance about what they see coming in 2023, and so everyone is in a holding pattern. But when 4th quarter earnings season starts reporting in January 2023, companies will not only have another quarter of softer results to report, but will finally have to offer up their guidance for the new year. I think at this point analysts will have the cover they need to finally bring down their earnings estimates for 2023 to reflect the slowdown we are going to see. That’s when we finally get a market bottom. I also expect it will take several quarters after this until we know the full extent of the recession, however markets will likely start to price in a recovery early in 2023 as they anticipate a better 2024. By then we should have a clearer picture of what is to come post the 2023 slowdown that almost all professional money managers see coming. Right now however, it is unclear if we are going into a short, mild recession or something more painful.

 

  So investors with cash positions will be well advised to hold off on any major purchases in the stock market until at least the first quarter of 2023. The trend remains downward and one should not try to front-run a major market trend, or the FED, who has repeatedly said they have more work to do, they will continue to raise rates and then keep them higher for longer than we think. We should believe the FED because they see their greatest mandate right now is to fight inflation, not to save the stock market or the economy.

 

  My advice is to keep some cash in money market instruments yielding 4% for short term income needs (the next 12 months), buy investment grade corporate bonds with staggered maturities, but nothing longer than 12 months, and wait for the final shoe to drop early next year. CIBC Autocallable Coupon Buffer Notes also would work well, yielding between 9% and 12% via a monthly coupon payment and with principal protection. As your bonds and notes come due, look for investment opportunities in financials, industrials, healthcare, consumer cyclicals and energy sectors. Avoid adding to technology stocks for now, as we are only beginning to see the restructuring this sector will have to go through to right-size their operations for the next decade of higher interest rates, higher inflation and slower growth. Their valuations are still very high. Income investors might also want to look at adding some longer term (ie 5 years) bonds to benefit from the eventual decline in interest rates that will come once inflation is under control. These bonds will rise in value when this happens, and will add to the returns of what are excellent coupon yields at these levels, and which will not exist when rates decline.

Stocks to avoid are ones with high debt levels, low or no profitability, stagnant growth prospects, weak pricing power needed to maintain margins, or highly competitive markets in mature industries where operating margins are constantly under pressure, or industries that are very capital intensive. An example would be AT&T, whose debt level is $130 billion, which is higher than it’s total market capitalization, with no earnings growth, and is bleeding cash with a negative free cash flow of $0.51/share in 2023. Earnings estimates for the next two years are below current 2022 earnings and the industry is mature and fiercely competitive, offering no pricing power. The dividend, while high, could be cut in future years.

 

  As always, if you would like to talk about anything mentioned in this letter, or would like to review your portfolio in light of the inflationary cycle we are now in, please call or email me. We would be happy to arrange an in-person meeting (or via telephone or virtual) to review your portfolio, or discuss any matter related to your financial well-being.

 

Gordon Forsey Advisory Group:

Gordon Forsey P.Eng., MBA, CIM, FCSI

Portfolio Manager, Sr. Wealth Advisor

gordon.forsey@cibc.ca

Tel: 902-420-6203

Andreas Demone BBA

Client Associate

andeas.demone@cibc.com

Tel: 902-420-9624

Terri MacPhail

Client Associate

terri.macphail@cibc.ca

Tel: 902-420-8263

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