Panic, Capitulation, or Anger?
This week we discuss where we are in the market cycle, why pessimism sounds smart, and give our thoughts on recent results.
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Panic, Capitulation, or Anger?
“There's a storm coming, Mr. Wayne. You and your friends better batten down the hatches, because when it hits, you're all gonna wonder how you ever thought you could live so large and leave so little for the rest of us.” – Selina Kyle to Bruce Wayne in The Dark Knight Rises
This quote from one of my favorite trilogies (tied with the Lord of the Rings), has been coming to mind frequently over the past few months. While the context is quite different (here Kyle was referring to a social rebellion), the sentiment often makes me reflect on how when in 2020 the world was throttled by a pandemic and millions losing their livelihoods (or worse, their lives), the stock market cheered. Now market forces have come full circle and stock market participants are wondering how they could have lived so large and forgotten that eventually the bill would come due.
The bill has certainly come due, with a rough year-to-date performance across global equities. As of this writing (20th May Asia time) the S&P 500, MSCI All-World, and Nasdaq are down ~19%, 18%, 28% respectively. Granted, the worst of stock performances so far have been from covid-winners like stay-at-home stocks, e-commerce players, and euphoria-driven excesses such as SPACs. Considering how hot they ran, it’s understandable that the crash has been just as severe. However, over the last few weeks most other parts of the market have started to roll over including value stocks (the Russell 2000 value index is down 18% from its peak and 14% YTD) and retail stalwarts (this week Target saw $25 billion in value wiped off its market cap in a few minutes). In fact, every sector of the S&P 500 is down for the year, most significantly so. Except for select commodity stocks there has really been no hiding from this continued drawdown.
The above chart has been uncannily accurate as we go through the current market cycle and it’s a decent guide as to what to expect next. The question on most market participants mind is where we are in this chart. Most would guess given the market moves recently that we are somewhere between “Panic” and “Capitulation”. I believe the market is a bit more bifurcated than that and covid-winners and zero-profit tech are in the “Capitulation/Anger” stage (I’ve noticed a lot of disgust toward management of these companies recently) and are trading at covid-lows or even worse. On the other end of the spectrum some of the market “generals” are just beginning to be shot and are likely in the “Denial” stage (ahem… Apple which still trades at a 23x P/E despite very low top and bottom-line growth expectations).
Now it’s easy to see what’s missing in this graph, and that’s levels and timing. While we could very well be in the “Capitulation” stage, there is no real indication of how deep that goes and for how long. Market cycles follow similar shapes but do not follow similar depths or time horizons. For example, March 2020 saw the period from “Capitulation” to “Depression” to “Disbelief” last just two-three weeks as Fed stepped in to buoy asset prices.
The question now becomes how far down this “Capitulation” stage will go. Some investors I’ve spoken to believe we’re just about near a bottom as we are reaching peak fear but are seeing some light (China reopening, inflation rolling over, inventory glut) but others think a 2000/2008 type correction is possible. I tend to be in the camp that we’re closer to the bottom than not. Simply because the last two occasions we saw such extreme drawdowns was first when financial markets seized up and banks were declaring bankruptcy and second when we were in a pandemic that we believed would kill all our loved ones. In comparison, even with hot inflation the current macro environment is relatively benign. We are also starting to see capitulation in the form of funds shutting down, with Melvin Capital (made famous by the GameStop saga) announcing it will return investor capital after its difficult performance over the last few years. I’ve been backing up our thinking that we may be close to the bottom by stepping up our buying recently. I will admit it hasn’t felt good doing so but taking short-term pain for long-term gain rarely does (in investing or in life).
But many investors disagree with me and believe this drawdown will be more like a 2000 or 2008 scenario. I struggle with the 2008 scenario thinking as for those of us who remember clearly, we literally thought financial markets were going to meltdown. It was the modern equivalent of the 1929 bank runs. With employment across the world generally being high, strong financial systems, low relative rates, and strong consumer demand in recovery industries (dining, travel, transport etc) it’s hard to say we’re in a meltdown. A recession may happen, but it’s not guaranteed.
However, the 2000 type scenario is far more plausible, considering it too was driven by a tech-led boom and bust cycle. The parallels with the 2000s are quite clear. Non-profitable tech was trading at ridiculously high multiples, and every dumb idea seemed to receive inordinate amounts of attention and funding. However, this data (source, Gavin Baker) helps paint a picture that shows that as crazy as the 2020s were, the 2000s were twice as bad.
In this table we can see that multiples at the peak of 2020 were 44% less than the peak of 2000. And with the correction underway we are already at valuations 60-70% cheaper than 2000 multiples on a forward basis, and nearly 80% cheaper on a trailing basis. Part of this is because of stock prices coming down, but also because earnings per share have continued to rise since peak valuations in 2020 (whereas they fell after the peak in 2000). Certainly, we could see an EPS decline in tech stocks moving forward especially if there is a recession, but mathematically we would need to see earnings per share decline over 60%-70% to get to a 2000 type drawdown. This seems, well, extreme.
Nothing, and I mean nothing, when it comes to predicting the future is certain (which is itself ironic). So, we must assign probabilities based on the data we have available, which, of course is what investing is (betting on probabilities). But as someone assigned to invest my client’s capital over the long-term if I’m not spending my cash now when valuations for some of our holdings are completely bombed out and potential holdings are trading at salivating levels (ie we are finding companies trading at near $0 enterprise value), I feel like I’m not doing my job right. I could, of course, be wrong. There are no guarantees, and I always operate on some assumption that I’m wrong, so we are still holding some cash and securities we could quickly turn to cash and are still trading in and out off hedges. All that is to say that at this time, while that Dark Knight quote has been ringing in my head for a while, it is slowly being replaced by another which states that “Every current/future drawdown looks like a risk, but each one in the past looks like an opportunity.”
As usual, none of this is investment advice, and every investor must do the right thing for themselves, their stakeholders (may they be clients or family members), and in the end, the best move is always the one that helps you sleep well at night. So, if you can’t take the pain anymore, and prefer to be in cash – then perhaps that’s the right move. Just make sure that current FEAR doesn’t turn into extreme FOMO later.
I wish you all the best in the ongoing volatility. Thank you for reading, and happy investing.
Farrer Fun Fact
Real price of gas: Due to technological advances, most vehicles are now far more fuel-efficient than those from a decade ago. Thus, despite the surge in oil prices, the real price of gasoline is still a bit away from historical highs. (source).
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