We’re now close to 12 months into this current bear market cycle, arguably longer if you count the start of this cycle as when technology stocks started to correct (remember that was all the way back in mid-2021). This is probably a good point to reflect on the current bear market cycle and try to put it into perspective. The question every investor is understandably asking themselves is: when will this bear market cycle end?
Looking at previous bear market cycles in financial markets is helpful here. There have been twelve major down trending market cycles since the end of the Second World War. Taking a simple mean average of the peak-to-trough declines in those bear markets, we find that the average cycle saw a 33% drop in major stock indexes. We also find that the average length of the cycle was 12 months.
Peak to trough the S&P 500 Index has seen a decline this year of 25%. The Nasdaq Index more than 35%.
We’re definitely not in a position to call the end of this current bear market cycle simply because its now older and as deep as the average bear market. But, and this is an important ‘but’, we can say with confidence that, to quote Winston Churchill, ‘… it is perhaps, the end of the beginning.’
We are seeing areas of the market and specific stocks where valuations are now much more attractive. In fact in some cases there are quality assets trading at their lowest valuations in history. However these remain the exception rather than the rule. This leads us to remain somewhat cautious on the short-term volatility and direction of markets. The current bounce in markets is likely another bear market rally and we could see further tests of lows in the new year.
Despite this less sanguine view for the short-term, we remain bullish on the long-term outlook for high quality businesses trading on now much more reasonable valuations. We continue to favor a targeted strategy of averaging in to these investments, rather than attempting to time the bottom of the current market cycle. There will likely be further opportunities into the end of this year and 2023 to add to equities on possible new lows.
The good news for long-term investors is that, so long as the entry price is attractive and quality of the assets being bought are high, short-term volatility and potential new lows in markets simply offer even better opportunities to add more to these favored investments.
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Update on market valuations ...
This week we offer an update on our thoughts around market valuations, risks, and most importantly, areas of speculation in financial markets which we still think look like bubbles.
On a series of webinars we hosted last year, we made the point then that investors needed to be wary of multiple speculative investment bubbles that could burst. We saw highly speculative price movements and valuations in asset classes (if you can call them an asset class) like crypto currencies. In the stock market, there were many businesses with valuations that honestly made no sense to us.
Tesla
Tesla, for example, was trading on a valuation of $1.1 trillion, which was greater than the value of every other car company on the planet combined. To put $1.1 trillion into context, the annual Gross Domestic Product of the Netherlands is less than $1 trillion (a G20 economy).
Bitcoin
Bitcoin and other cryptos, we were promised by their backers, were on the cusp of reaching record highs and changing the world, displacing fiat currencies like the old fashioned US dollar, euro, pound sterling and Japanese yen. Prominent evangelists like Sam Bankman-Fried, founder of crypto exchange FTX, sat on panels alongside Bill Clinton and Tony Blair, his face even ending up on the front cover of Forbes and Fortune magazine.
Companies with poor business models and little else other than bullish forecasts commanded outrageous valuations. Zillow Group, a US-listed business that bought homes and then re-sold them online (garnering it the much desired label as a ‘tech’ company) commanded a peak market valuation of $41 billion despite consistently generating negative profits.
Another electric car company cunningly named Nikola (a la, Nikola Tesla) had a peak valuation of $29 billion last year, despite having no working prototype of an electric vehicle and publicly publishing videos of what looked like a working prototype but was actually a model vehicle being rolled down a hill. I’ll just repeat the valuation, $29 billion. To put that into context, one of the world’s largest defence contractors, (the UK’s biggest), owner of some of the most advanced intellectual property anywhere, BAE Systems, currently has a market valuation of $29 billion (and it generated $2 billion of profits last year).
Which would you rather own now?
The aforementioned eye-watering valuations, and many, many more, of last year could not last and these multi-bubbles have been bursting. Some quickly, others more slowly. Tesla stock is down 55% from peaks last year. Bitcoin is down 60% so far this year alone, and is down 71% from peak last year. Other cryptos have fallen 100%, literally losing all their value, while some related businesses (investment funds and exchanges) have filed for bankruptcy. Sam Bankman-Fried is now allegedly on the run following the collapse of his business and allegations of fraud, his location currently unknown and the topic of speculation in the press.
Nikola’s share price, down 96% from peaks last year. Zillow is down 82% over the same period.
Investors must, however, remain very cautious. There is a joke among professional investors that goes something like this: ‘what do you call a stock that’s down 90%? It’s a stock that was down 80%, then it fell another 50%.’
The math of the joke is simple. Take a stock starting at a price of 100, it falls 80%, so the new price is 20. Then it falls another 50% from there down to 10. That is a start to finish fall of 90%. The moral here is that just because an asset has seen a big fall in price, it can still fall a lot more!
Investors must be very cautious, given the big falls we have seen in speculative bubble assets over the past year, not to fall into the trap of thinking they now offer good value at these lower prices.
Dominion Capital Strategies
Bitcoin can still fall 100% from current prices. We remain highly sceptical of all cryptos and see much danger still lurking in that space for investors. Similarly, while some stocks have lost most of their values and rightly so relative to where they were trading last year, others still exhibit speculative excess in valuations, even after the big declines we have seen. Tesla, for example, with a current market value of $590 billion, remains a risky prospect, as do many other stocks.
Some bubbles burst quickly, others more slowly. We think there’s more to come on the downside for the likes of bitcoin, et al.
Dominion Capital Strategies continue to see much better value elsewhere, and that’s where we’re investing.
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Summing up what we wrote last week...
Last week, as part of our ongoing series on long-term investing, we introduced the idea of ‘going up the value chain’.
To summarise: we think investors who want exposure to long-term growth themes in the global economy, like climate change mitigation or artificial intelligence, should beware of investing in the more obvious front-line businesses exposed to that particular trend, which can often be overcrowded and so over-valued. Typically, the least crowded and most interesting investment opportunities when investing in structural growth trends are discovered by mapping out and searching for investments within the broader value chain for the relevant industries. This process of building out a universe of businesses with differing exposures to the same trend can uncover diverse and appealing long-term investment opportunities at much more attractive valuations.
This week...
We can apply this methodology to an investment theme which touches all of our lives, quite literally. Human health and wellbeing is undoubtedly one of the most important of the investment trends we research at Dominion. There really is nothing more important than the health and happiness of our friends, family, and fellow humans around the world. This is also a trend of extraordinary magnitude, with many sub-trends converging to create a global mega-trend which is transforming billions of lives.
New and emerging medical technologies to treat disease, ageing populations, emerging markets and increasing global wealth, changing cultural attitudes towards wellness and mental health, the utilisation of existing technologies to improve quality of life. All of these seismic changes in the world are happening at the same time and translate into a structural investment trend that investors can gain exposure to: that of people around the world living, on average, longer, healthier and more meaningful lives
As investors we can be part of the solutions to many of the problems standing in the way of all humans living long, healthy and fulfilling lives. When you buy shares in a business that is, for example, offering genetic testing services to help detect and treat cancer, or a company engaged in early stage research to discover new drugs to treat dementia, you as an investor are supporting that business via your capital allocation decisions, effectively providing the capital base for those companies to continue investing in their services and technologies. As capital allocators we really can change the world in a positive way by allocating investments to businesses facilitating change.
Mapping out the value chain in the global health and wellness trend is especially interesting since we are, by the very nature of this trend, having to look at everything from frontier technology in genetic medicine, to businesses involved in looking after the health of pets (a healthy dog makes its owner much happier!). Robotics companies researching and developing ways for people with disabilities to be able to walk again, businesses who provide the services to correct eye-sight problems, suppliers of high quality services to care for the elderly, education providers training the next generation of doctors and nurses, even the manufacturers of the components used in vaccine production. The value chains we can gain exposure to by digging deeper into the theme of human health and wellness is incredible in its scope and breadth.
As people live longer, their need to access healthcare and wellness services increases. As populations live longer, the trend of ‘ageing populations’ supports structurally rising demand for related healthcare products and all of the services that make up the wider value chain already discussed. This is a powerful and predictable driver of an investment trend, and it is self-reinforcing too. As current and emerging technologies help people live longer and healthier lives, it prolongs their lives and thus increases future demand for health and wellness. This positive feedback loop is a powerful driver, if investors can gain exposure to it, for compounding returns on investment over the long-term.
Having some portfolio exposure to this theme also offers an additional risk mitigation benefit. The demand for health and wellness has a low income elasticity of demand and is often subsidised by governments. This means that during periods of macro-economic uncertainty, as we are currently very much living through, the demand for healthcare and related products and services is often largely unaffected. If someone is diagnosed with an illness, they are going to seek out the best treatment they can find and it will increasingly often be an insurance company or government paying, and so the relevant service or treatment remains in demand, whatever the economy may or may not be doing at that moment in time.
It therefore makes a lot of sense for investors to look at their portfolios and ask themselves: am I appropriately exposed in this trend? Given the ongoing uncertainty for the global economy going into 2023, it may even make sense for investors to ask themselves: should I make exposure to this trend a core investment position for my portfolio over the next 12-24 months, not just to gain exposure to one of the most exciting growth themes out there, but to also help my portfolio weather a volatile and uncertain outlook for the global economy.
When selecting investments exposed to major growth themes in the economy, one of the mistakes investors make, even many professional ones, is to invest in the most well-known or direct exposures they can find.
For example, by far the most popular way to invest in the electric car revolution over the past five years has been to own Tesla stock, the electric car company pretty much everyone knows. Another example is in climate change mitigation, where renewable energy companies like solar panel manufacturers have been very popular places to invest.
But what's the problem?
The problem with this is twofold: first, it means that the limited number of these investments can become so popular that their share prices rise out of proportion to the quality of the company, and so become overvalued. An overvalued investment is typically going to offer lower long-term investment returns, as investors its our job to find under-valued investments. Second, investing in these more crowded ideas limits the opportunity set for us. Often there are not that many pure-play electric car companies, or wind turbine manufacturers, for example, and so with a limited opportunity set it is difficult to diversify our investments.
How to use the chain to our favour...
A way around this is to do something we at Dominion call, ‘going up the value chain’. In any industry there will be what is known as a ‘value chain’. This is the chain of services and products that supply into an end product. Each stage in the value chain will often be an entire industry in its own right. Let’s use one of our aforementioned examples.
Tesla is a well-known, and quite crowded, way to invest directly in the electric car trend. But Tesla is supplied by many companies who manufacture or own the designs to complex components like battery packs, sensors, even interior products like seats. Then there are the automated robotic systems in Tesla’s factories, then there is the software that those factories run on.
Already we have touched on half-a-dozen separate industries which facilitate the manufacture of electric cars, and in each there are companies we can invest in. If Tesla sells more electric cars, it also demands more of these second-order products, services, and software to produce more of those cars, and so we can still play the same trend, but in a smarter way by going back up the value chain.
Here are some examples:
And we do not have to stop there. Again, continuing our example, we can go back up another step of the value chain. Who supplies the component manufacturers and software suppliers, who themselves supply Tesla and other electric car companies? In this case, there is another set of suppliers who produce, for example, the brushless electric motors that go into the car seat, or who code the software that automotive component suppliers use to design their products.
Again we can invest in these third-order players who still have exposure to growth in electric car demand.
Dominion Capital Strategies
This process can be continued until eventually we reach the other end of the supply chain. In the case of electric cars, this brings us to mines. Literally the mine face of a copper mine, this is where the process starts in the production of an electric car, at the rock face of a mine in Peru, or Indonesia, perhaps Chile, or Mongolia.
The metals we need to produce complex products like an electric car, or a solar panel, or an iPhone for that matter, are primarily produced from mining operations digging this stuff out of the ground and processing it to produce metals like copper, cobalt, nickel, and steel, without which none of the long-term investment trends we and anyone else invests in would be made possible.
In the case of some trends, like electric cars, the input materials like copper and cobalt make up a significant proportion of the cost of production. This means that even at the opposite end of the value chain for their supply, the increase in demand for the end product (electric cars) will also increase demand substantially for the primary product (copper, cobalt).
Then, how do we invest effectively?
This means we can effectively invest in the trend at any stage of the value chain, from car production, to component supply, software services, to mines producing the primary metals. This opens up a much broader array of opportunities in which to take advantage of the trend, and critically also means we have a better chance of finding a means to invest which is less crowded and offers a lower entry-point valuation for us as investors, thus improving our investment returns outlook.
This way of thinking can be repeated across any major investment theme in the global economy. For example, in artificial intelligence or cloud computing, the upfront providers of these complex systems are often big tech names like Alphabet (owner of Google), or Microsoft, and these are fine companies to be sure. We would not turn our noses up at owning them. But once again, we can go back up the value chain.
What infrastructure and components do Alphabet, Microsoft, et al., need to run these cloud and artificial intelligence systems? What about the software needed to design and produce those components? There is an entire universe of businesses doing just those things, critical suppliers to the cloud computing giants, owners of the technologies that power the computers running artificial intelligence algorithms. Once again, by thinking about going up the value chain, we open up a much broader opportunity set for us as investors to play the same trend, but in a much smarter way.
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Summing up what we wrote last week...
Last week we identified four primary characteristics we think are critical when deciding which trends to invest in for the long-term.
As a reminder these were: (i) the scale of the change (i.e., you want the trend and its implications to be as big as possible), (ii) the breadth of the trend (ideally there are multiple angles from which to play the theme), (iii) predictability (the more conviction we can have in the expected outcome, the better), and (iv) valuation (current valuation levels for companies exposed to the trend should be attractive).
This week, we’ll give an example which matches these criteria but also expands further on them. It’s important for long-term investors to remember that you do not need an investment trend to necessarily be driven by revolutionary new technology or, in the case of last week’s episode, literal change in the earth’s climate. Sometimes it can be the application of existing technologies in new and innovative ways that can create a significant enough change in the world to match our strict criteria for long-term investing.
Software is nothing new...
It is the code that tells computer systems what to do. Mathematicians, starting with Ada Lovelace in the 19th century, wrote software for computers before computers had even been built, they did this in anticipation of their creation.
A new development in recent years, though, is cloud-based software offered as an ongoing service to users, known as SaaS (software-as-a-service), and the application of this software into fields which have traditionally not seen very much innovation in IT.
There are many areas of the modern economy which have seen little change in communications and IT technology for decades. Some sectors, like entertainment for example, have seen radical change, moving from analogue broadcasts of TV and radio signals in the 1990s to high-definition streaming of music and video direct to the home and mobile device today, but other sectors over the same period have effectively stagnated.
Healthcare is a primary example here. While medical technology has advanced considerably in many aspects, the software and IT systems relied upon by national and local healthcare bodies have not. It is not uncommon to see fax machines, communication by letter or text message used by hospitals in industrialised nations like Japan or the UK. Similarly, many healthcare systems and companies operating in drug research and development will often not have any unified data collection and interpretation software systems at all, instead relying on a maze of siloed data sets and missing out on the opportunities of a joined-up system.
Things are changing, finally, and potentially in large part due to the pandemic
The COVID 19 pandemic which started in 2020 created a pressing need for healthcare systems to try and cope with unprecedented demands on their services, while also navigating entirely new challenges like developing and then distributing vaccines to hundreds of millions of people. The old way of doing things wouldn’t work and as such, existing technology and software providers who had solutions for healthcare were brought in to help make the changes needed to meet the challenges of the pandemic.
The reluctance of healthcare to trial and use new technologies is understandable in normal times. The cost of failure is so high, literally people might die, that trialling and implementing new systems for communication or data collection, are often avoided, while old processes, despite their inefficiencies, are at least known to work and so usually remain the preferred option.
But the pandemic has changed this. SaaS and data science businesses which might have taken a decade to establish themselves as providers to the healthcare industry have been fast-tracked in to help deal with the unprecedented challenges of COVID. And in many cases, they worked.
The vaccine distribution plan for the United States and United Kingdom (combined populations of 400 million), where more than 90% vaccine uptake was needed with multiple vaccine types and doses per person needed, was handled by a single SaaS business which had hitherto seen little success in providing its services to healthcare. That same business is now looking to be the first technology company to fully unify the UK’s labyrinthine healthcare system onto one digital platform, which could save the health service there hundreds of millions of pounds and save thousands of lives.
Even outside of healthcare we are seeing SaaS businesses save lives with existing platforms being used in new ways. Cloud-based software businesses like Cloudflare, which operates a global server network and offers low cost cyber security services, has a system advanced enough that it was able to detect the digital signatures of a likely Russian invasion of Ukraine before the event. It was instrumental in supplying Western governments with the information they needed to warn and prepare Ukraine for the eventual invasion.
What is more, Cloudflare’s systems are powerful enough that after the invasion started and Russia attempted to shut down Ukraine’s capacity to communicate, Cloudflare was able to keep Ukraine’s internet up and running, a critical advantage which, along with the forward notice of the invasion, contributed significantly to Ukraine’s success in repelling Russia’s initial invasion.
These are just two examples of world changing, life-saving applications of existing SaaS business models. Software has evolved beyond just offering us spreadsheets and useful ways to video call each other. It is saving lives and in the second example we gave, helping to preserve European democracy. Not bad for lines of code.
Looking forward...
You can see how this trend matches our investment criteria for long-term trends very nicely. The implications of this trend are already huge, with a broad array of applications and ways to play the trend. And with markets seeing a major correction this year, many of the companies providing these software services are now trading at 80 to 90% discounts to prices from just a year ago, and so valuations are now much more appealing too.
We are not just excited about the investment opportunity here. We are genuinely excited to see how software services like those already mentioned and many others will transform the world for the better in coming years, helping in every aspect of human development, from disease prevention to education, from the alleviation of world poverty to radically improving healthcare outcomes and protecting Western democracy, the future in this trend is likely to be an extraordinary journey… and a journey with significant rewards for investors who get it right.
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Summing up what we wrote last week...
Last week we introduced the idea that investors should be thinking about the long-term and investing accordingly. This translates into trying your best to ignore short-term noise in financial markets and to instead focus on investing in relatively predictable sources of growth.
This week, we’ll take this idea a step forward with an example. But first, let’s discuss the characteristics we’re looking for in more detail that define an ideal long-term investment trend.
Substantial:
First, we want it to be substantial, in other words, the bigger the trend is in its scale, the better as this creates a larger source of potential value creation from the scale of the change.
Broad:
Second, we want broadness too, in the sense that there are multiple angles from which we can potentially invest in the trend. The more diverse the opportunities to invest, the better.
Predictability:
Third, we want as much predictability as possible. As discussed last week, predicting the future is extremely hard, so the more predictable our investment future is the better. Finally, we want a good entry point in terms of valuations. There’s no point investing in a trend if valuations of the potential investments are already so high it precludes investing in the first place!
Summary:
To summarise this, our ideal long-term investment trend is: (i) substantial, (ii) broad, (iii), predictable, and (iv) good value.
Climate change is a great first example here. It is, arguably, the optimal long-term trend from the perspective of the first three of our criteria. It is substantial, in fact that is an understatement. Tens of trillions of dollars of capital will have to be invested over the coming decades into transitioning the world away from fossil fuels and into alternatives, while also mitigating other sources of emissions in complex and varied industries from agriculture to construction.
Climate change as a theme is very broad, offering opportunities to invest in every sector and in every geography, since this is a global problem that touches every sector of the economy.
But, is climate change predictable?
It is also predictable to a certain extent. We do not necessarily know the timing of climate change, its effects, or the pace of mitigation efforts, but we can say with a high degree of certainty that it will involve a lot of investment in greener generating capacity (wind, solar, nuclear, grid infrastructure investment), it will also certainly require major investment in energy efficiency and technologies that do more with less energy across multiple sectors, from air conditioning systems to transportation technologies, from street lighting to data centres, all will increasingly be looking for solutions to reduce energy consumption.
The path to investing in long-term trends is, hopefully, becoming clearer. We are not making specific predictions about what the profit or loss on a particular business will be next quarter, or next year.
Dominion is making predictions about the likely 5-year, 10-year, and 20-year path for demand for products and services they know for a fact already works at supporting this trend. And they have the reassurance of the understanding of a trend we know offers considerable margin of safety for investments, in the form of its scale, breadth, and predictability.
The more research we do, the clearer it becomes to us, for example, that climate change mitigation does not work without major new investment in nuclear power, and so we can invest accordingly. Similarly, it’s almost impossible to reach net zero without major demand increases in renewables and associated input materials, and so we can invest accordingly.
Now you may have noticed we have missed out one of the characteristics of our ideal investment trend, the last one: ‘good value’.
Does investing in these sectors as part of the climate change trend offer good value?
Value is a function of the price paid and the quality of the asset, whatever you are buying. Optimally you want low price and high quality. The quality part takes time to research, but we can assure you, with respect to climate change, quality is out there in buckets. And everyone knows prices of virtually all stocks have been coming down this year, especially so in some of the suppliers into this trend.
Hopefully this is now putting the current market weakness into context as an investor. Nine months of weak stock markets, from the perspective of the long-term minded investor, simply dramatically improves the value function. In other words, the same quality exposed to the same long-term trend is now on sale at much lower prices!
For the long-term minded investor, now and over the coming months, with prices and valuations much lower compared to the past decade, is a very attractive opportunity to ramp up positioning in a long-trend like climate change, or in an investment strategy with exposure to this trend. Further price weakness in markets only makes that opportunity look even more attractive.
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Last week ...
Last week Dominion said that investors should be wary of focusing too much on the past, or on the current situation in markets, and try to instead think about the long term. What will the world look like in 5, 10, or 20 years-time, this is what matters for investors, rather than the immediate news stories of the day, whether they be about inflation, the economy, or (as is sadly the case currently in the UK), political incompetence.
This does beg the question: well, what do you mean by ‘thinking about the long-term’?
In other words, what does that mean and how do we apply that as investors in a useful way?
First, an admission. Predicting the future is hard. Really hard. Accurately forecasting the weather more than a week in advance is beyond the ability of the world’s most powerful super-computers. To use another unfortunate analogy from the UK, predicting who will be our Prime Minister next week is beyond the ability of the world’s most powerful super-computers!
If predicting the future is so hard, how can we ever get comfortable investing for the long-term?
What is critical here, and we’re echoing a view shared on a previous episode titled ‘known knowns’, is that investors recognize what things we can predict accurately as well as what we cannot predict accurately. To use an oversimplified example, I have no idea what the weather will be like in two weeks-time on Monday, but I do know the sun will rise and can even tell you the exact time it will rise.
So, what can we predict and how do we use that to our advantage as investors?
Long-term structural growth trends are major changes happening in the world that we can predict with some accuracy over prolonged periods. If we can identify beneficiaries of this change, we can in some cases invest in those beneficiary business models and, in theory, benefit from the structural change happening over the medium- to long-term.
Here’s an example, which we will dig into in much greater detail in the next episode. We know that the world’s climate is changing, with average temperatures rising because of modern human civilizations' use of fossil fuels as a source of power. We also know that there is growing government and private sector action to attempt to tackle this issue. This is not an accurate prediction of what temperature rises will look like specifically, or which specific companies will benefit from investment in climate change mitigation.
But it is a direction of travel for the world that we can predict with an elevated level of confidence. That is the base from which we can start to zero-in on specificities of the trend which we can be confident about, which then can lead to making investments.
There are many trends like this which we can, with high degrees of confidence, predict will happen in some form and as such, set the stage for making investments in companies we think will be beneficiaries of the trend.
Over the coming weeks, we will be digging deeper into some of the biggest long-term trends that we are thinking about, and which offer investors very appealing long-term investment opportunities.
The recent market volatility and declines in equity markets make this especially timely as the entry prices for many of the stocks exposed to these trends are now much lower and so offer even more appealing long-term return profiles.
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Current volatility ...
Given the volatility and economic uncertainty investors have experienced this year, we think it makes sense to review the state of markets, expectations, the economy, and most importantly, take a constructive view of how investors should be positioned to navigate this.
Global markets continue to be volatile. Bonds as an asset class have had their worst first 9 months to a year in history. At the same time equity markets have seen significant declines. The S&P 500 Index is down 23.5% YTD in 2022, which is close to where the market was in February of 2020, just before the pandemic-led sell-off. Adjusting for inflation (remember inflation reduces the real value of assets), and the S&P 500 is down closer to 34% so far in 2022 and is below 2020 levels.
Meanwhile inflation continues to surprise to the upside. Last week US core inflation again increased over the previous month, raising the prospect of yet more interest rate rises needed to curb inflation in the world’s largest economy. The ongoing real estate crisis and relentless zero-covid policies in China are weighing heavily on the world’s second biggest economy. Europe faces a tough winter ahead with record high energy prices and an economy already likely to be in recession.
Is there any good news here?
Well, yes, there are a couple of important factors that are easy to miss, but critical for investors to remember
First, investors are often guilty of spending too much time looking backwards, i.e., focussing on recent past performance, recent negative news, while spending too little time looking forwards. It’s easy to understand why. Looking backwards is easier, it is known information, we know what happened in the past. Looking forwards is hard, and can be scary. The future is unknown and uncertain.
Looking forward and with a long-term investing mind-set, we can say with some certainty that inflation in the US will subside (eventually), China will re-open (eventually), and Europe is already shifting away from a reliance on Russia gas supplies towards a more diversified energy mix, and as such energy costs will come down (eventually).
Investors must be careful not to get trapped in the news stories of the moment, and remain focussed on the future, which offers great investment opportunities, especially so in structural trends in the economy.
These trends are not going to be stopped by short-term factors, like inflation, pandemics, or even wars. The rise of the global middle classes in emerging markets, adoption of new technologies in healthcare, artificial intelligence, cloud computing. These are just a few examples of the incredible investment opportunities for long-term minded investors and as such should not be avoided now because of short-term concerns.
Second, as already mentioned, markets have come down a lot so far this year. Adjusting for inflation, the Nasdaq Index is down 43% in 2022! That is a major correction in prices. As painful as that is to swallow for investors with exposure to the market, it also means we are much closer to the end of the price correction than the beginning. It also means many of the stocks that offer exposure to those aforementioned long-term structural growth trends are now trading at much lower prices vs. 1-year ago. In many cases they are trading on their lowest prices ever!
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We continue with Dominion Capital Strategies series on current financial markets...
During the 1992 US presidential election campaign, James Carville, then a strategist for the Bill Clinton campaign, coined the phrase “it’s the economy, stupid.” George H. Bush was the incumbent president at the time, and the US was in an economic recession. As such, the Clinton campaign focussed its messaging on the principle of: whatever else people may like about George H. Bush’s first term as president, all that really matters is the state of the economy.
In the third part of our series on likely catalysts for the next bull market cycle, “it’s the economy, stupid!”. This phrase is helpful, as it was for Bill Clinton during his 1992 campaign, as a reminder that the state of the economy is by far the most important factor for us to be thinking about. Weaker economies tend to precipitate weaker financial markets, and vice versa. Thus, understanding the trajectory of the global economy in the remainder of 2022 and into next year, is vital for understanding the path of financial markets for investors.
The conundrum facing markets at this stage, however, is that while normally a stronger economy (all else equal) would be good for markets, at the moment the opposite is true. A stronger economy now in the short-term would be bad news. Why?
The difference today is excessive inflation.
It’s easy to forget we had rates of inflation in the developed world of less than 2% in 2019-2020, which had persisted more or less for 30 years. Today’s US headline rates north of 8% are the highest in four decades and, as such, central banks are focussed on bringing down inflation. Their fear (which is justified) is that allowing inflation to run hot for too long can embed higher inflation expectations into the economy. In other words, the population come to expect higher inflation and adjust their wage expectations and spending patterns accordingly, which further increases inflationary pressures on the economy. Such ‘inflationary spirals’ can last many years (1970s-1980s) and cause severe economic distress.
Central banks, therefore, want the economy to slow down to bring inflationary pressures under control, and they are doing this via higher interest rates. This leaves us with the aforementioned conundrum.
Good news for the economy, strong jobs data from the US for example, or higher than forecast consumer spending… this implies to markets that inflationary pressures will remain elevated and so interest rates will have to rise even further to slow the economy.
Right now, stronger than forecast economic data, without a corresponding decline in inflation, is bad news for markets, as it implies continued hawkish central bank policy and higher rates.
This makes the final of our bull market catalysts the most complex one to discuss, as it requires a period of bad news before the good news. In effect, we need the economy to slow down, first, to bring inflation under control, and it is only once inflation is back in its box, that we can interpret strong economic data as good news for risk assets.
The positive news on this front is that, as we discussed last week, there is early evidence that input prices for the economy have fallen in many cases from highs seen earlier in 2022, and as such, we should expect inflationary pressures to ease in coming months. With interest rates now much higher than they have been in well over a decade, this should (in theory at least) act as a break on the economy and bring the desired short-term slowing in economic activity needed to control inflation.
This brings us to our conclusion on bull market catalysts.
We have, you will remember, discussed three important catalysts we think would drive a new bull market cycle in stocks: (i) a pivot or pause in central bank policy, (ii) a decline in inflation, or (iii) a change in the economic situation.
It’s important to note here, that all three of these potential catalysts are linked. Inflation has a major effect on the economy and on central bank policy. Central bank policy also impacts the economy and levels of inflation. But most importantly, it’s the economy and its performance that drives everything here. Excessive economic activity relative to the supply of goods and services is what is currently driving inflation, and the continued strength in the economy through a bout of inflation is driving economic policy. It is, therefore, the economy where we must look first for evidence of a change in direction for markets.
Given the inflationary situation, this means looking for an economic slowdownfirst, before a recovery. It is the slowdown that will precipitate a pivot in central bank policy, and a reduction in inflation.
We will, therefore, over the coming weeks and months, return to the nuances of the latest economic data in an attempt to find, and report to you, evidence that our bull market catalysts are coming into play. This will, we think, when it happens, mark a critical moment for investors to consider maximising allocations to equities.
In the meantime, investors should, we think, continue to opportunistically add investments to specific strategies where valuation and quality are the primary criteria, while continuing to maintain ‘dry powder’ to further ramp equity exposure over the coming months before the next bull market cycle begins.
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This week, we continue our series on the likely catalysts for the next bull market...
It's important to recall that throughout 2022, and especially in recent months, Dominion Capital Strategies has reiterated their view that this current bearish cycle is not yet over, with more risks for investors. This will eventually end and a new bull market cycle will come for stock markets, the question is when and what will drive that sustained upward movement in stocks?
Last week we looked at Dominions first episode on "bull market catalysts" series, which includes a shift in central bank policy, and why this outcome would precipitate a new bull market cycle.
This week, the second episode of their catalysts series will explain why investors should understand what a sustained decline in inflation is.
Inflation levels remain stubbornly high around the world, near their highest readings in forty years. The wide rise in price levels is the ultimate cause of the current bear market cycle in asset prices. It was higher inflation that triggered central banks to raise interest rates and reduce market liquidity, an ongoing process that puts downward pressure on the prices of all assets.
This leads us to ask:
If there were a significant decline in inflation from here, what would that mean for markets and investors?
The answer is: it depends. It depends on the nature and causes of any decline in inflation. A significant supply-side response – that is, higher prices across the economy incentivize an increase in the supply of goods and services, thereby bringing prices back down, causing inflation to fall – would be a very positive outcome. This would certainly drive a new bull market cycle in stocks.
However, if from here inflation were to decrease because high prices destroy demand, acting as a brake on the rise in prices, the end result would be an economic recession, the decrease in corporate profits and the consequent fall of the stock markets. This result would prepare us for the next bull market cycle, given that it would still kill the inflation monster, but we would have to go through a recession first.
Which of the two is more likely? In Dominions opinion, probably a mixture of both. There will be a supply-side response to higher prices. A good example is here in the UK, where oil and gas drilling and production activity in the North Sea has increased to full capacity to produce as much energy as possible to supply the UK and Europe, in light of Russia's disconnect from its supplies to the continent. A similar activity will occur in all supply chains experiencing price increases.
At the same time, rising inflation and the consequent rise in interest rates are also destroying demand. We are seeing a significant slowdown in consumer demand in areas such as electronics, as well as clear evidence of the slowdown in the real estate market around the world. This, in turn, is reflected in a growing set of economic indicators that signal a possible recession.
The combination of these factors already translates into a drop in prices in many of the main inputs of the economy. Prices of most commodities have fallen sharply from the highs reached at the beginning of the year. Other input costs, such as freight and components, have also seen their prices fall from much higher levels in early 2022. Wage inflation remains positive, but it has not run rampant in the same way it did during the inflation cycle of the 1970s.
In real terms, the average worker in the U.S. and Europe has suffered a pay cut this year. Sharp rises in house prices in 2021 have stalled and in some places are being reversed. These are all leading indicators of official inflation data, meaning that we should start to see official inflation figures go down.
The timing of this is uncertain, inflation is slippery and has historically been incredibly difficult to predict, but there are reasons to be progressively optimistic that much of the inflationary pressures may begin to ease in the coming months. Now, it could be a slow process, with bumps in the road, but the direction of travel is becoming clearer, and that's good news for long-term investors.
When official inflation figures begin to fall steadily, this will be a strong catalyst for more stable equity markets and increase the likelihood that a new serious bull market cycle will begin. And we'll be the first to tell everybody. From here it requires patience on the part of investors, but we are getting closer and closer to the moment when we can call, with confidence, the next bull market cycle.
