"When the time comes to buy, you won't want to."
-- Wally Deemer
The markets over the first half of the year continued to be among the most difficult to navigate in years.
However, if one is able to endure a bear market with limited damage and drawdown, long positioning in the later stage of a bear market and into a more healthy market environment sows the seeds for superior longer-term investment returns.
Buyers Live Higher, Sellers Live Lower
I was bearish during the last half of 2021 when equities, importantly influenced by a few generals (FAANG+M) and by the machines and algos -- who know nothing about value and everything about price -- were revered by the consensus and when the averages seemed to rise almost daily, effectively proving, to take the opposite of Wally's wonderful quote above, "when the time comes to sell, you won't want to."I believe that a more healthy market backdrop may lie ahead.
In early June 2022, I wrote in my Daily Diary on Real Money Pro about my less cautious market view and the possible emergence of sounder values.
I am not dewy-eyed or Panglossian as my still high cash position of more than 50% speaks volumes. While I respect the policy challenges and the difficult path to stability in achieving a soft economic landing, I am growing increasingly, and incrementally, more bullish on equities -- in part based on our expectations of a mild and brief recession and a possible rapid deceleration in the rate of inflation which could result in a less hawkish Fed.
The confident optimism of 2021 has morphed into the unsteady fear and uncertainty of 2022, and the Pollyanna strategists of late 2021 have been mostly converted to being Cassandra-like in July 2022.
Investor sentiment, as noted in my recent Bloomberg interview here (at the 32 minutes, 35 seconds mark) is sour and worsening, along with lower prices.
Hedge funds and retail investors have considerably de-risked and de-grossed. Several high profile and formerly successful hedge funds have effectively folded under the pressure of poor performance and redemptions. This happens at bottoms, not at tops!
As a further example of negative sentiment, Bank of America's Bull/Bear Indicator hit zero two weeks ago. The last few times this occurred were in August 2002, July 2008, September 2011, September 2015, January 2016, and March 2020 -- all periods of time that it paid to buy equities.
The following factors, and buffers, will likely serve as a ballast to the U.S. economy and suggests a briefer and milder economic downturn than is generally expected by the consensus and in what appears to be reflected in much lower stock prices:
-- The absence, in large part, of the sort of leveraged positions and segments of the economy that have characterized previous deep economic down cycles.
-- Unlike 15 years ago, and in other previous economic downturns, our banking system is far less levered and has sizeable cushions of liquidity and capital.
-- There is over $2 trillion of excess consumer savings.
-- The days of no doc and lo doc mortgages are over, FICO scores are at near record highs and loan to value mortgages are at historically low levels. Importantly, the consumer possesses a cushion of sizeable unrealized/imbedded gains in the nation's housing stock.
-- The U.S. has a very strong industrial/corporate base that has generally improved their balance sheets by rolling over into inexpensive debt over the last five years, and that have maintained high profit margins.
-- We have a robust and tight labor market -- with solid wage increases a highlight of the last several years:
-- The U.S. unemployment rate stands at 3.6% -- the lowest level since the start of the pandemic and only 0.1% above the 50-year low of February, 2020:
-- Some important components of inflation are moderating -- the prices of most commodities have fallen considerably over the last 2 1/2 weeks. Copper is -33% from its all-time high in March, 2022 and at its lowest level since 2020:
-- Corn, wheat, and soybeans are all down over 25% from their highs and below the levels they were at before Russia invaded Ukraine:
-- Used car prices are -7% over the last six months:
-- The price of energy products have also fallen precipitously -- that decline has accelerated Tuesday morning with the price of crude oil down by nearly $5/barrel:
-- Here is a final chart that demonstrates that we may have reached "Peak Inflation":
-- Interest rates may have peaked. The yield on the 10-Year U.S. note is more 50 basis points below its recent high. (I own a load of Treasuries.)
-- Developing signposts that the supply-chain disruptions are slowly being resolved.
-- China, the engine of global economic growth, is no longer foundering as signs of economic stability and growth are emerging.
I further expand upon this more optimistic thesis in my Daily Diary Tuesday. But I want to emphasize that gazing into the rear-view mirror is not the key to delivering superior investment returns as markets are forward looking. Consider, for example, how murky conditions were in early 2020 as Covid spread. The market rally from that point -- or uncertainty -- in time was spectacular.
I remain struck by the changed market zeitgeist between late 2021 when we were negative. Back then we saw a preponderance of negative optionality of expected outcomes. By contrast, today circumstances are quite different and we see the potential for a positive optionality of expected outcomes.
In summary, we have rapidly moved from a period of gross and excessive speculation, elation and complacency on the part of most market participants and the expectation of only positive outcomes -- to a period in which speculation has been decimated, investors have de-risked and de-grossed, stock valuations have been reset lower, fear and the VIX are rising, and with the general consensus expectation now consisting of mostly negative outcomes.
Bull markets and investment opportunities, 2009 and late 2018, are borne out of bad news just as bear markets, summer 2007, early 2020 and late 2021, are borne out of good news. This phenomenon helps to explain why "when it is time to buy stocks, most investors do not want to."
While conditions are admittedly far from ideal the negative headwinds have now become accepted and, arguably, are in the process of having been partially discounted.
Evidence of a Market Overshoot to the Downside?
History suggests the potential for positive forward returns following deep six-month drawdowns:
This chart indicates that bad starts to the year often leads to a second-half recovery:
Based on empirical evidence, if the recession is mild and brief, stocks have likely overshot on the downside, and the prospective decline in 2023 S&P EPS will be modest:
Bottom Line
With a contrarian view and a calculator in hand, I have been slowly and steadily expanded my net long exposure over the last several weeks.
My baseline expectations are for a mild and short-lived recession and "peak inflation." This view and a sense of history are some of the core reasons for our more optimistic market view which is reflected in my higher net long exposure.
We may now be approaching the polar opposite of late 2021 when The Bull Market in Complacency, the absence of fear and disregard towards sky high valuations, were prominent market features.
Unlike 2021, inflation will soon be demonstrating signs of moderation and global economic growth will likely move into a sluggish mode which is not necessarily a bearish development.
With stress, fear and "aversion" to stocks now palpable and with the drumbeat and hubris of the bullish cabal beginning to recede, I believe it may be time to slowly but steadily use one's cash reserves to buy bargains which are appearing with greater frequency these days.
Subject to my continued assessment of the macroeconomic backdrop and of my more favorable view of individual equities, I expect to cautiously and incrementally expand my net long market exposure as opportunities arise.
(This is excerpted from commentary in Doug Kass's Daily Diary on Real Money Pro July 12. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns and trading ideas each day from Paul Price, Bret Jensen and others.)
