Posts tagged: Finanzas

As of Friday morning, equity markets over the past week have jumped sharply. S&P 500 is close to its highest levels in 6 months and is now +17% up from its lows in October. It is easy as an investor to submit to market sentiment shifts like this, especially when they happen quickly.

The ‘fear of missing out’, or ‘FOMO’, is a powerful force in explaining global capital flows during periods like this. Just as a severe downturn in equity markets can result in widespread fear among market participants, which itself feeds back into the decline in prices, the opposite can also be true. A sharp move up in prices can start to feed itself, as market participants extrapolate the recent price moves and improved sentiment out into the future. The simple act of prices moving up itself feeds more positive sentiment, which leads to more buying and even higher prices. Nobody wants to be left out of the rally.

When prices move like this, an obvious question to ask is: why? Or better yet…

What are these prices reflecting in terms of expectations for the future?

Markets look forward. That means that the price of a liquid financial asset you see today, say for example, the stock price of a technology company, or the price of a government bond, those prices reflect market expectations for the future. If expectations improve, i.e., they become more optimistic about the future, all else equal, the price of the asset should rise. And the opposite is true too, if expectations deteriorate, all else equal, the price of the asset should fall. A sharp rise in prices of risk assets, as we have experienced since October, reflects improved expectations for the future.

This is what is meant when people talk about ‘what the market is pricing.’ What version of the future is implied by the current prices of stocks, bonds, etc.

Sometimes, those expectations for the future (bullish or bearish) can diverge from reality. The collective expectations for the future in January 2022 were overly optimistic relative to what actually happened. Reality caught up with market prices, and reality usually wins in the end. The collective realisation by market participants that the expected outcome (reflected in asset prices) is different to the realised outcome, can result in sharp changes in prices. This is often the fundamental underlying driver of sharp moves up or down in markets.

If we look at markets today, what are they pricing in?

Let’s start with equity markets. Last year saw a sharp decline in developed world equity prices, led by the US, as the economic reality of 2022 (higher inflation, slowing economy, raised geopolitical risk) triggered a negative change in expectations and thus in stock prices. The recent rally in stock prices implies an improvement in outlook. In other words, equity markets are telling us that talk of recession is premature, meanwhile risks of inflation and higher interest rates are now less of a concern.

Bond markets, meanwhile, are telling a somewhat different story. The shape of the yield curve tells us that bond markets expect a sharp decline in inflation and a potential recession. We’ll skip an explanation of what yield curve inversion means this episode, but suffice it to say, whenever it has happened in the past, there has been a recession. It’s been a very reliable lead indicator of an economic slowdown, and right now it is inverted (and has been for some time).

So… to risk oversimplifying: the equity market is telling us to worry less, 2023 will be fine, meanwhile the bond market is suggesting a recession is probably more likely than not. Both do agree on one thing though, both agree on a rapid decline in inflation.

This, we would argue, is the risk investors need to be thinking about.

If all market prices are pointing in one direction (in this case, to disinflation) and reality moves in the other direction (higher than expected inflation), that is where price dislocations can be their most severe.

How should this affect portfolio decisions in 2023? We continue to stand by our previous view, that pockets of value exist which can immunise investors from needing to think too hard about macro-economic outcomes.

If you’re buying expensive assets (expensive = high price relative to profits / income generated by the asset) then you do need to worry about inflation, interest rates paths, economic outcomes, etc. But if your portfolio is weighted toward owning assets trading on more reasonable valuations (low prices relative to profits / income), those concerns become much less relevant to your investment return outlook.

Rather than committing to one economic outcome over another in 2023, we prefer to defer on economic predictions, and stick to what we know works over the long-term, a deep focus on asset valuations and asset quality. This is also helpful advice for investors who want a good night’s sleep!

It’s easy to forget, but last August the S&P 500 rallied +16.5% from its lows, the Nasdaq Index clocked a +23.3% rally in the same period. Some market commentators at the time went as far as to call the end of the bear market in light of the strong short-term performance seen in US equities.

We published an episode at the time, questioning whether or not that rally would last, beginning a new bull market cycle for stocks, or a bear market rally doomed to end, a short-term move up in prices during a broader down-trend in the market. We called it right then, seeing the balance of risks continuing to the downside, a bear market rally it was.

Nasdaq hit a new low for this bear market cycle last month in December, the S&P 500 index in October. Since then, however, we find ourselves in a similar position to our past selves last summer. We’ve seen a strong short-term rally in stock prices. Since recent lows S&P 500 is up +13%, Nasdaq Index +12.2%.

As with last August, this now again begs the question, is the recent rally in stocks the opening act of a new bull market recovery, or is this yet another bear market rally?

What are the arguments in favour ?

What evidence is there for this being the start of a new bull market cycle? This is a relatively simple thesis. Inflation is coming down, corporate results and the economy remain relatively healthy, if there is a recession it will be mild and there might not be a recession anyway. China is re-opening, and the European economy is not in as bad shape as previously thought, thanks largely to a mild winter (and lower drag from high energy costs). Meanwhile equity prices have fallen and so market valuations are much more attractive now. Market sentiment was, in December, quite bearish, and this historically has been a good signal to buy stocks.

What about the argument in favour of this being another bear market rally. Let’s go back to last August and review the state of affairs then. Inflation was falling, it peaked in June in the US. Corporate results and the economy remained in relatively robust form, and the expectation was that there might be a slowing in the economy, but the recession (if it comes) will be mild. This sounds familiar.

We have been here before. Bear market rallies are common. In the 2001 bear market cycle, S&P 500 rallied 22%, Nasdaq 43% before both moved down to new lows. Some of the strongest short term rallies in history have been bear market rallies.

2023 News ...

What’s new now vs. August last year: (i) China re-opening, (ii) expectations for the European economy are improving (not falling), (iii) interest rates have risen further and are closer to terminal rates. The first two are clear economic tailwinds and likely have supported the recent rally in stocks.

Interest rates rate rises may also pause soon, that’s good news. But we would caution against premature celebration of a pause in interest rates. A pause is no cut. We’re likely some way off a cut in rates. Further, looking at the four biggest bear markets of the past century, even when rate cuts do arrive, they do not necessarily coincide with market lows. In 1929, 2000, and 2007, bear market years which all saw an initial interest rate cut by the Fed, the subsequent respective moves in US equities were down 79%, down 41%, and down 55% respectively.

Economic indicators for the US economy also appear to be going in the wrong direction. Some industrial companies we follow, 3M and Atlas Copco are two good examples supporting the more negative data outlook, both companies have broad exposure to the global industrial economy too, both have reported results weaker than expected and with outlooks for slower growth in 2023.

So where do we stand on this?

The underlying story remains one of caution, in our view. There are reasons to be optimistic if you are an investor with a long-term time horizon, but we continue to think markets could test new lows again later in 2023.

How can we be simultaneously pessimistic (new lows this year) and optimistic (long-term)? We think the investment outlook today is a little like the difference between the weather and the climate. Imagine a wet day in Paris, in July. We might forecast more rain in the coming days, a negative short-term forecast, but remain very confident that dryer weather is coming in the longer-term because we understand the climate and average weather patterns one should expect in Paris in July.

Similarly, we think the fact that interest rates are unlikely to be cut for some time, the economy is likely to slow at least somewhat in 2023, and the full ramifications of higher interest rates are yet to feed into the system, are strong enough reasons to remain cautious on the short-term market outlook. The tailwinds of China re-opening and better Europe vs. expectations could support the rally in the short-term, but the underlying global story of higher interest rates, likely slowing in the US economy, and still elevated equity valuations vs. history, mean we continue to see a risk of further bouts of market weakness.

The good news here echoes what we have been saying for some time now. Valuations in many parts of the market warrant buying now, whatever the short-term outlook for the market may be. That’s exactly where investors should be focussed, in our view, buying quality assets at reasonable valuations, holding them for the long-term, and trying your best to ignore short-term noise in markets, bullish or bearish!

Every three months, the financial world stops what it is doing and listens to what the corporate world has to say about the performance of their businesses, industries, and their outlook for the near future. This is, of course, earnings season!

Why is earnings season so important for investors?

This is where the rubber meets the road. As investors we are fundamentally taking a view on the future every time we invest in a company, a stock, a bond, whatever the asset class. If we invest, for example, in the stock of a cloud computing business, one of the inherent views we are taking on that business is that it will continue to grow sales at a high rate and that operating margins will rise as that business matures.

Every quarter, the listed companies in that industry (as with all others) report and update their financial results publicly. This allows us as investors and the market to assess the reality of the performance of these businesses and reassess the validity of assumptions and forecasts. This process of informational update feeds through into the prices of those stocks. Better than expected results should, all else equal, lead to higher share prices, and vice versa.

The information the market receives every earnings season also helps to inform wider economic expectations, again feeding through into the prices of assets in financial markets. If many of the companies in, for example, furniture retail, report weaker than expected results and predict a slowing in demand next quarter, this can be read as a warning for broader consumer confidence and consumption patterns for the economy.

To cut a long story short, earnings season is critically important even in the best of times, and especially so in periods like now where there is great uncertainty about the future trajectory of the economy and financial markets.

So what should investors be looking out for this earnings season?

The elephant in the room is the US economy. Increasingly it is expected that the interest rate rises of last year should feed through into a slowing in the US economy, especially hitting consumption of goods hardest. Retail and online ecommerce businesses who rely on consumers buying goods will be important bell-weathers for US consumer demand and its outlook.

Similarly, how is enterprise spending looking? This is a great unknown currently. Will companies be cutting back their spending on IT, software, hiring of staff, etc. in response to the higher interest rates, inflation, and possibility of a slowing economy. This is an important sector in the economy and stock markets.

For those companies in China or with exposure to China, the re-opening of the Chinese economy and the expected impact on results later this year is going to be a major story for investors to follow this earnings season. Do the relevant companies think consumption patterns will return to pre-pandemic levels… will there be new or adjusted consumption patterns which may change things for certain industries? These will be important questions to answer.

We can also get a view on the likely potential trajectory of inflation from earnings season. Management teams will sometimes refer to their input costs and expectations for how that will pan out in the coming months. This can give us a head start on headline inflation expectations. For example, we’ve already had the CEO of a major consumer products company say publicly that they are continuing to see input cost inflation headwinds, and they do not necessarily think the inflationary cycle is over. What is the wider corporate world saying about inflation this earnings season? Another important one to be watching out for.

This year, we’ll be running a series of episodes on what we think are underappreciated narratives, ideas which should be mainstream in modern economic and investment thinking but which are rarely talked about. Underappreciated ideas can offer interesting long-term investment opportunities and so are important to think about.

For this episode, we want to take you 30 years into the future. The year is 2053, and we are in a metropolis of 40 million people, a cultural and economic centre for the world’s third biggest economy, an economic giant with a population of 800 million and the centre of a regional economy with a population closer to 1.3 billion. We are in Lagos, the largest city in Nigeria, and we’re witnessing the outcome of the next great miracle in the modern global economy’s story.

Capitalism and industrialisation can change things so quickly, it’s hard to remember what the world looked like in the recent past. It is easy to forget that the great economies of East Asia (Japan, China, South Korea) were, not that long ago, low income countries with small economies and widespread poverty. China was an economic minnow in the 1990s. In 1993 China’s GDP per capita was lower than that of Uganda. Twenty years later it’s an economic superpower and a viable challenger to the United States as the world’s largest economy.

Most people’s careers last 45-50 years, followed by retirements of 15-20 years in many cases. This is an investment period for the average investor of 60-70 years. If China can rise from economic obscurity to economic superpower in just 20 years, it’s not fanciful but actually quite practical to be thinking now… who’s next, and can we invest in that story!

Nigeria’s GDP (economic output) has increased 6.3x since 2001, its GDP per capita 4x. And we are seeing a similar economic miracle play out across much of West and East Africa too.

Nigeria is emblematic of the wider opportunity from economic development in Africa. West Africa, and much of East and Southern Africa, is (on average) culturally diverse, with relatively open societies, developing democracies, and legal systems much more closely aligned with European or American systems. In the long-term these are powerful ingredients for economic success.

America’s early democracy, political, and economic development were not a smooth ride! It was a bloody and volatile road to becoming the modern economic and cultural giant the United States of America is today. Many would have laughed at the idea if, in mid-19th century London or Paris, you had suggested that America would dominate the planet within a century. Similarly you may have even been mocked (as your author and narrator once was, literally), for suggesting in the late 1990s that China would become a superpower on par with America within 20 years.

To suggest that this story is over, that China was the last new economic superpower rising from obscurity, doesn’t hold water.

We are already seeing India fast become the new kid on the superpower block, and we think it’s wise to think 15-20 years ahead to who will be next. West Africa is a strong candidate.

What does a story like this mean for investors today? It means thinking about investment allocations for the long-term that take into account what the world could look like. Assuming the poor stay poor has been a terrible bet over the past 200 years. Emerging markets across the world, currently thought of as destinations for aid spending or maybe an ‘adventurous holiday’ by many in the West today, are the economic giants of tomorrow and will be sooner than you think.

What’s more, we as investors can get in at the ground floor on many of these opportunities, via investments in Funds with exposures to these markets or mandates with the flexibility to allocate to emerging long-term trends like these.

Extrapolating the present into the future rarely works. We’re extremely excited about the future and, what’s more, we’re especially excited about future structural trends which are not well appreciated… because that usually means they are under-priced!

It may be difficult to remember, but at the beginning of last year global financial markets were in a bullish mood. Equity markets and bond markets were close to all-time highs. Real estate, private equity, these asset classes too were trading on valuations at or close to their highest levels in history.

Then came a series of negative surprises through the year: continued rises in inflation to the highest levels in four decades, war in Ukraine, an energy price spike (most notably in Europe), COVID lockdowns in China.

When optimistic expectations (reflected at the start of last year as high asset valuations) met a series of unexpected negative events, asset prices declined and volatility increased. This process reflected the mis-match between what the market thought was going to happen vs. what actually happened. That was the story of last year, a bear market for stocks and bonds, as asset prices started off too high relative to what actually then transpired in the real world.

When we look at the starting point for investors this year, it’s a very different story. Expectations have been reset much lower over the past year (reflected in asset markets by lower valuation levels today).

Inflation is known to be high and is actually now falling in many parts of the world. Energy prices have declined from their peaks last year. Energy costs in Europe are coming down. China is reversing its COVID lockdown policies and re-opening its economy.

Could 2023 end up being defined as having started with pessimistic market sentiment (reflected in lower asset valuations) which then met a reality that was better than expected. The polar opposite of 2022. Lower asset valuations meeting better than expected outcomes, all else equal, results in prices of assets rising.

The balance of expectations and valuations at the start of this year is much more in our favour as investors than was the case at the start of last year. Market expectations today are much less optimistic than they were this time last year.

The lower your starting valuations for assets, the smaller the price declines will be from each incremental negative surprise, and vice versa, the higher the price rise will be from each new incremental positive surprise.

If your starting position is one where market sentiment is overly pessimistic, this increases the probability of positive surprises.

Identifying a moment of overly pessimistic sentiment in markets correctly can therefore be very rewarding for an investor willing to commit to buying assets and thus benefitting from subsequent price rises as those positive surprises roll in.

This begs the question: Are we there yet? Is market sentiment today overly pessimistic, thus creating the opportunity to buy assets and benefit from the asymmetry in positive vs. negative surprises to expectations?

For markets as a whole, we would argue: not yet. We continue to think we could see tests of new lows for stocks in the first half of 2023.

But in some sectors, asset classes, and individual stocks, we are there now. In those specific cases, valuations and sentiment are too pessimistic and offer the opportunity to take the other side as an investor.

This means now is the time to be buying those assets, and to continue buying through 2023. We think some areas of the commodity sector, especially those linked to climate change mitigation, offer such opportunities. Emerging market value is another one.

We have been cautiously but steadily buying into specific sectors and stocks we see as offering this opportunity, the opportunity to, as Warren Buffett puts is, be greedy when others ae fearful.

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.