· General Summary on how 2022 ended
· Inflation Updates
· Why markets behave in certain ways towards the end of the year/tax consequences
· My macroeconomic “outlook” and opinion
· Interest Rates, Yield Curve, and Their Relation to Economy/Stocks
· My Sector Positioning/What I am Invested in heading into 2023
The boring stuff is in the beginning, so bear with it. Gets a bit more interesting towards the end.
Summary of End of 2022
Towards the end of 2022 (November/December) we saw relative stability in the markets with the stock market trading in a tight range, and we saw bonds actually rally towards year-end (treasury rates declined). The winners of 2022 (value stocks) continued to outperform the losers (technology/growth) heading into year end. Volatility in markets cooled off as investors paused for further clarification on inflation, unemployment, earnings, and the overall health of the economy. 2022 marked one of the worst years ever for financial markets, with a typical 60/40 portfolio (stock/bonds) having its worst year in a century. The S&P declined by about 20% in 2022, the Nasdaq declined by more than 30%, but the Dow Jones declined by only 9% in 2022. This makes sense as the Dow Jones is made up of value-oriented, dividend-paying, profitable blue-chip companies, which investors salivated over in 2022. The Nasdaq is technology heavy, which obviously experienced 2000-like tech bubble carnage in 2022. The S&P is the middle ground, making up a more diversified market-cap weighted index of the 500 biggest and profitable companies in the U.S. Fixed income such as treasuries and corporate bonds actually rallied towards year end as rates cooled off. Compared to the first 10 months of 2022, the last two months were an opportunity for investors to catch their breath and think about strategies going forward that might be different from the strategies that worked generally in 2022.
As discussed below, I think 2023 will be very different from 2022 and presents many opportunities for investors willing to take a bit of risk. At the end, I’ll discuss what I am specifically invested in.
Inflation:
We already started to see significant easing in inflation and headline CPI numbers (as forecasted in the prior article). November CPI came in at only +0.1 month-over-month and December came in at NEGATIVE (-0.1) (that is deflation). (While January inflation readings were hot, I think these are due to seasonal effects and are likely one-time outliers in the months of lower inflation to come). If you annualize the last 6 months of CPI, you get merely 1.8% annualized inflation. Even though inflation peaked and deflation probably began several months ago, CPI is a lagging indicator and the full inflationary/deflationary effects only become apparent in the data months down the line. Also, that 1.8% annualized number only takes into account data from the most recent 6 months, which still had significant monthly inflation in September/October. The recent trend for inflation is definitely lower and I think we will see deflationary numbers going into 2023, especially in the second half. I will once again reiterate that investing purely on economic predictions is a fool’s errand (sort of), unless conditions become so one-sided that the contrarian position offers an enticing risk-reward (which I think is happening now). I’m not saying to make bets on what you think each month’s CPI will be, but rather, to look at how overweight money managers are on assets that perform better in inflationary environments, and the potential reversal that can take place if conditions quickly change.
One example of why CPI is a lagging indicator and will likely plummet in the next several months is the shelter component of CPI, which accounts for almost 1/3 of CPI. Shelter cost (based on CPI collected data) is still increasing significantly month-over-month, masking the larger deflationary numbers we would’ve had in December if those calculations were more up-to-date. As explained in previous articles, the shelter component of CPI is calculated weirdly – simply put, it takes an average of the last twelve months cost of shelter (which is calculated by rent amount or owner’s equivalent rent). Anyway, the point is not to get too technical but to point out that because of the Fed’s actions, we have seen a sharp decline in rents across the nation (according to many surveys, experts, etc.) that have yet to be fully incorporated into headline CPI numbers. Once the more recent data is incorporated fully into headline number calculations, we will likely see a sharp downturn in CPI.
Decline in energy prices have contributed greatly to slowing inflation. Volatility in oil prices can depend on many factors, including unpredictable geopolitics, so I won’t talk too much about it, except that history tells us oil prices tend to decline during economic downturns and Fed-induced recessions.
I still cannot believe how many professionals and “experts” refuse to acknowledge the massive shocks in our economy which have put a halt to inflation. I think the inventory buildups by retailers, improving supply chains, and massive financial tightening still has ways to go in reducing inflation and likely putting up deflationary numbers in 2023. FYI, “experts” still predict we will have 2-4% inflation at the END of 2023 on top of the staggering numbers we had in 2022.
I could very well be wrong, but the risk-reward on betting on lower inflation/deflation is too enticing to pass up for me, especially given the carnage in long-duration assets such as growth stocks and long-term bonds.
Year-End Action and Tax Consequences
In November and December 2022, we saw sectors in the market act pretty much in line with how they did generally in 2022. Tech and growth stocks suffered further declines and value/ defensive/dividend-paying stocks outperformed significantly. This year-end performance is not shocking at all because of tax-consequences. Investors have losses mounted in the ‘losers’ of the year such as technology and growth stocks, and thus sell towards year-end in order to tax-loss harvest (use their losses to reduce taxable income). On the flip-side, investors refuse to sell the ‘winners’ of the year (industrials, energy, consumer staples, healthcare, etc.) because they don’t want to book gains before the end of the year and owe massive taxes. So because of the mechanics of filing taxes, the end of the year generally causes losers to underperform and winners to outperform, which is what we saw happen.
However, as the new year has come, these mechanical and non-fundamental movements in stocks create opportunities for fundamental investors looking towards the future. Money managers tend to rethink their strategies and positioning in the new year, and it is likely that “regime-changes” (not to sound too dramatic) occur after the start of the new year as opposed to the end of the year. This potential “regime-change” I refer to is quality growth and technology companies outperforming again because of extremely depressed valuations, and the seemingly “safe” and “value-oriented” companies trading at historically high multiples underperforming because of how over-owned they are.
Macroeconomics
While inflation numbers have cooled off in the last couple of months, unemployment and jobless claims show that the economy is still somewhat resilient. However, these numbers also lag the actual data and don’t fully reflect the national employment scenario. Technology companies have been halting hiring and laying off employees pretty aggressively. Financial companies have cut back hiring and started firing as well. The carnage in the labor market is in white collar jobs, and if we have a recession, it is likely to be a white-collar recession.
I think that a slowdown is on the way and if the Fed does not pause the breaks, a meaningful recession is possible. Regardless, I do not make my bets on just predictions, but rather the risk-reward scenario. “Defensive” and value-oriented companies like Coca Cola, Nike, Proctor & Gamble, United Healthcare, Walmart, and many others are trading at HISTORICALLY high multiples. These are near zero-growth companies trading at premiums to the S&P’s market multiple of 17. I think an incredible amount of optimism is baked into these stocks and many money managers are overweight these blue-chip value companies that the risk-reward is definitely to the downside. For example, why the heck would I pay 30 PE for Walmart, a company with zero growth, inventory surplus, and heading into an economic slowdown. Investors currently have gravitated towards these stocks because they are considered "recession-resilient."
If we do end up in a recession, I see all these richly valued “safe” or “value” companies absolutely plummeting as investors realize they are paying 25x for a zero-growth or negative-growth company while heading into a recession (and likely declining earnings). Money managers are currently overweight these value companies and will use it to raise cash if needed. Additionally, I see the DOW and S&P indices performing poorly as they have held up relatively well compared to many individual stocks. I see quality technology and growth stocks, especially those with secular tailwinds and/or recurring revenues, outperforming in a recessionary environment because of the immense valuation cuts and pessimism already priced in. In a recession, longer-term rates generally decline as investors flock to safety, which is a tailwind for technology/growth companies whose profits are discounted from further in the future. Many money managers are now underweight technology compared to historical levels and very pessimistic about the sector, not leaving many sellers to push the prices even lower.
I think we are in a rare opportunity where you can buy some of the highest quality and innovative companies in the world at historically low multiples. As a bonus, once we start the next cycle of economic growth, whenever that may be, the technology and growth companies which make it through and cut costs in the meanwhile will become more profitable than ever with accelerating growth ahead. Investors with a time horizon of 5 years + will probably find their patience very rewarding.
Interest Rates, Yield Curve, and Their Relation to Economy/Stocks
Additionally, the yield curve (depending on which curve you look at) is currently inverted/flat, at least the 2/10 year or 2/30 year are. Generally, in healthy economic times, shorter term rates should be lower than longer term rates because tying your money up for longer implies more risk. If the market fears a recession, investors generally flock to longer term treasury bonds as safety, pushing long-term yields down. Currently, we have a somewhat inverted/flat yield curve, warning investors of an impending slowdown or deflationary environment.
As to how this relates to stocks in particular, an inverted yield curve which signals an impending recession means that earnings are likely to decline. In general, there are two primary levers which affect a company’s market cap: earnings and the earnings multiple. A recession would lower the earnings component of this dynamic leading to lower stock prices. Earnings multiples generally move based on rates (higher rates = lower multiples). Multiples have already compressed a good amount to reflect higher rates, so any further decline in the stock market is likely to be caused by a sharp decline in earnings (if a recession occurs).
However, this cycle’s inversion might be unique and might not necessarily indicate an impending recession. It might even reflect the fact that inflation fears are short-lived and that we will soon put those fears behind us. The reason it might be unique is that we likely have a short period of unusually high inflation in the near term, requiring higher return on short term bonds. These shorter term yields have skyrocketed while longer term yields have increased at a slower rate. The reason long-term yields haven't skyrocketed at the pace of short-term yields is because investors probably don’t expect inflation to remain elevated for many years to come. This volatile and extreme rise (and eventual fall) in inflation might deceive investors who rely on nominal yield curves. Real yield curves (as opposed to nominal) based on inflation expectations might actually not be inverted. (Real yields = nominal yield - inflation rate; real yields/rates are basically inflation-adjusted yields/rates).
My Sector Positioning
I like to share how I am generally positioned so my words are not meaningless and reflect some actual action and investments. I most definitely am not advising that you copy or replicate my investments, but rather use it to better understand my opinions and thoughts. Also, the portfolio allocations I am about to describe below are for an aggressive, risk-taking portfolio (more fit for younger investors or people who don’t have the immediate need for the money).
A year ago, my portfolio was mostly value-oriented and I avoided high-growth stocks. My portfolio has almost completely flip-flopped in a year. I am now almost entirely long technology and growth stocks (the losers of 2022), and short all the sectors which outperformed in 2022. I am short several industrial stocks, energy stocks, financials, and consumer staples. The criteria I look at in shorting these “value” stocks is what PE ratio they trade at relative to the S&P, and most importantly, their historical PE multiples. Many of the stocks I am short are trading at all-time high multiples despite the fact that 1) rates are relatively high (compared to last decade), 2) an economic slowdown or recession is likely, and 3) the earnings comparisons in 2023 to 2022 numbers are going to be very tough. These once “value” companies are now trading at premium valuations and technology stocks have become the real value in the market because of how cheap they’ve gotten, despite the fact that many technology companies have stronger fundamentals and much higher growth.
Let’s look at two scenarios. The first is we have a significant economic downturn/recession. In this scenario, the broad market will likely sell-off and most sectors will suffer declining earnings. However, many technology and growth stocks are already trading at historically low multiples and likely pricing in a significant slowdown in their business, while sectors like industrials, consumer staples, and energy are trading near historically high levels, leaving much more room for declines in stock price if the broad economy heads south. Additionally, in a broad economic downturn, secular growth companies like many technology stocks (companies who have growth embedded in their business/industry independent of the macroeconomic situation) will likely experience less of a decline in revenue growth. Also, many software as a service companies whose stocks now trade at historically low multiples are very good businesses to own during a recession because most of their revenues are recurring, meaning that their customers pay them a subscription periodically. These contract-based recurring revenues are much more resilient in economic downturns than one-time purchases, especially since cancelling these software subscriptions would put the customers in jeopardy of greatly disrupting their businesses. Many enterprise software-as-a-service companies are crucial to their customers’ operations, and thus will likely see low levels of cancellation, if any. These recession-resilient software companies with recurring revenues are trading at bargains compared to historical levels as the whole sector has been annihilated in the past year because of rising interest rates. In an economic downturn, long-term interest rates will likely decline based on historical precedent (because investors buy long-term treasuries for safety), presenting another catalyst to these beaten down technology stocks that are considered ‘long-duration assets.’
In the second scenario, we have a “soft landing” as they call it and we only have a mild recession, if any, and things move along normally. In this scenario, these beaten down technology and growth companies will likely continue their rapid growth and once again demand premium valuations. Meanwhile, the sectors trading at historically high valuations (industrials, energy, consumer staples, healthcare) will likely remain flat and underperform since a lot of optimism is already priced in for these sectors (aka the upside is limited). Rates would remain somewhat elevated for a while.
Therefore, I have shorted the broad indices (SPY, DIA), industrials, energy, and consumer staples, and am long many technology and growth names (in addition to some other core blue-chip holdings). If the first scenario takes place (significant recession), my technology/growth longs probably don’t have much more downside given how much they’ve gotten hammered, and my shorts will likely do very well as the broad market falls, hedging any losses from my longs. If the second scenario takes place and we have a soft landing, my longs will do fine and continue their historical growth rates and continue to display strong fundamentals, and my shorts will likely not hurt my portfolio too much since the upside on those stocks is limited given they are trading at historically high multiples. In summary (and just in my opinion), the stocks I have shorted have limited upside and medium-to-high downside, and my longs have huge upside and limited downside. This creates an enticing risk-reward scenario to have a long/short portfolio while also hedging against a broad economic downturn.
As for my long positions, I will shortly publish a new article on the criteria I look for in specific stocks and why. I am long mostly mega cap technology, software-as-a-service, and ‘quality’ growth companies. I still have a few of my favorite blue chips as core holdings but a large majority of my long positions are more speculative and ‘growthy.’ (Again, this was the complete opposite in 2021 with my portfolio having almost no technology stocks, and only value-oriented names).
Here are some of my LONG positions (no particular order): $META, $GOOG, $TDOC, $AMD, $UPST, $BA, $CRM, $OKTA, $TWLO, $WFC, $DIS, $FVRR, $CRWD, $PUBM, $MDB, $QLYS, $ESTC, $TLT.
Here are some of my SHORT positions (no particular order): $DIA, $SPY, $WMT, $NKE, $HON, $CAT, $XLF, $PG, $OIH, $ISRG, $ORCL, $MCD, $APA, $XLE, $XLI.
More to come on these.
Conclusion
In summary, I expect 2023 and the years to come to be much different than 2022. 2022 was a huge reset and a historical year for the stock and bond market. It wiped out a lot of the speculation and excess in the markets from the COVID easy-money era. I think we are on track to have a more normal few years to come, with patient investors eventually reaping the rewards.
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