"An optimist is a person who sees a green light everywhere, while a pessimist sees only the red stoplight... the truly wise person is colorblind."
- Albert Schweitzer
Global equities are down nine days in a row -- the worst losing skein in over 11 years.
Along with lower stock prices, investor sentiment ("Price has a way of changing sentiment," h/t The Divine Ms M) has soured and many retail and institutional investors are positioned defensively based on the expectation that the market will soon breach the June 16, 2022 lows.
As I will describe in this updated market outlook, this contrarian with a calculator in hand is growing less cautious and taking advantage of the recent and relentless drop in stock prices:
* I don't see a break to new lows in the S&P Index.
* I see a trading range for the S&P over the balance of the year between 3800-3850 and 4200-4250.
* Equities now provide a reasonable upside reward vs. downside risk.
* My net exposure is still low at about 25%, but I am incrementally adding to my net long exposure into the recent weakness.
* I continue to see a mild and brief recession.
* Importantly, supply-chain bottleneck problems are easing, which will alleviate inflationary pressures, as noted below in a tweet this morning by my friend Liz Ann Sonders:
Safe to say supply bottleneck pressure is starting to become thing of past, with supplier deliveries components crashing in both ISM Manufacturing and Services PMIs pic.twitter.com/nOGsfI32lx- Liz Ann Sonders (@LizAnnSonders) September 7, 2022
* While inflation will remain "sticky" it has peaked and inflationary forces will decline measurably in the time ahead.
* The biggest headwind to equities is climbing interest rates which provide a bona fide alternative to stocks -- this limits the market's upside.
This missive is an adaptation of a letter that I sent out (last week) to the Limited Partners of my hedge fund, Seabreeze Capital Partners, LP.
In late July, my Diary outlined a more cautious market stance that I had adopted after the position-driven and machine/algo aided rally from the mid-June lows.
Many of our major concerns previously expressed four weeks ago remain intact:
1) While we have been in the "Peak Inflation" camp, we think inflationary pressures will be more stubborn than the consensus expects -- in our base case of a "mild and brief" economic recession. Structural headwinds to lower inflation remain -- wages, rents and the price of durable goods.
2) The easing of financial conditions in the summer has run counter to the Fed's intent. As seen over the past week, Chairman Powell and several Federal Reserve members have clearly pushed back the notion of a soft pivot -- that many on Wall Street erroneously interpreted.
3) I expect a continued hawkish Federal Reserve. A major difference between today and prior bear markets continues to be Fed policy. During the previous eight bear markets the Fed responded with easy money every time (with rate cuts and quantitative easing, etc.) This year the Fed is doing the opposite -- hiking rates and starting to shrink their balance sheet into a weakening domestic economy.
4) Non-U.S. economic prospects -- especially in China and EU -- have not improved. In fact, the global economic outlook has measurably deteriorated in the last two months.
5) I remain concerned about the buildup of private and public debt loads which, in the fullness of time, act as a governor to growth.
6) The earnings season, though better than many feared, has still not been good as forward guidance has disappointed and has raised more questions about prospective trends in profitability. Overall S&P profits are down year over year when adjusted for the strong contribution of energy companies. As previously discussed, the Producer Price Index (PPI) has eclipsed the Consumer Price Index (CPI) in each of the last 19 months - suggesting that companies will find it more difficult to pass on price increases and that consensus earnings expectations are likely too high.
7) Investor expectations and sentiment remain elevated, albeit lower than in July.
8) Though valuations have recently fallen, on average they still remain high relative to history.
To these eight factors, let's add two more concerns:
- The relentless strength of the U.S. dollar will adversely impact U.S. companies' profitability.
- The continuing rise in open market interest rates provides a competitive alternative to equities, as noted below in a column I recently wrote in my Diary on Real Money Pro: Goodbye TINA, Hello TATA
Employing 'Second Level Thinking'
It should be emphasized that, increasingly, all 10 of our concerns are slowly being recognized and being discounted. This is one of the core reasons why I am skeptical that the market has meaningful risk from current levels and why the 2022 lows may not even be breached.
A mild and brief recession is at the core of my more optimistic tone this morning. Here are some of the economic "buffers" that are supportive of our claims:
"At the core of my optimism regarding financial stocks are my expectation for a mild and brief recession, contained credit issues, a solid labor market, a relatively healthy consumer - armed with large unrealized gains in equities and in the housing stock - a still healthy housing market, a view towards higher interest rates (for longer), a strong and under levered U.S. banking industry/system with healthy structural economic underpinnings and, as a starting point, low relative (0.5-0.6x) and absolute valuations (8-9x)."
- Kass Diary, With Growing Macro Clarity, Banks May Emerge as a (The) Leading Market Sector in 2022-3 (September 6, 2022)
While I might be wrong in my market assessment, "second level thinking" remains a guiding force and ray of light for Seabreeze.
The market's immutable rule is that it will do whatever it has to in order to inflict the greatest pain on the greatest number of people. Thus far, 2022 has emerged as a good example of that rule.
The market remains one of the most difficult to navigate in my investing career. With the profoundly important changes in market structure as passive investing products and strategies overwhelm active investing, short term market moves are intense and exaggerated.
In the book The Money Game (1968), Adam Smith (the pseudonym for George Goodman) wrote that "if you don't know who you are, this (the stock market) is an expensive place to find out." At Seabreeze we may, at times, be wrong in market view but our path is clear and we know who we are. As T. Boone Pickens once said, "The older I get, the more I see a straight path of where I want to go. If you are going to hunt elephants, don't get off the trail for a rabbit."
* My strategy incorporates the notion of capitalizing on emotional human and price influenced non-human (algorithms and machines) behavior - as fear (and greed) incite trading/investing action far more urgently than does the impressive weight of historical evidence and the prospective fundamental outlook. Investors, it has been said, think in herds. They go mad in herds and they only recover their senses slowly. We try to take advantage of market participants' emotion - on both the long AND short sides. I firmly recognize that lower stock prices are the ally of the rational investor and higher prices are the enemy of the rational investor.
* "Second level thinking" is the watchword of my investing faith. Markets can rally when adverse conditions are discounted. This helps to explain why bull markets are borne out of bad news - and why bear markets are borne out of good news!
* I am a contrarian armed with a calculator in hand and balance sheets/income statements in the other hand. My fundamental and value orientation and my steadfast requirement of a "margin of safety" in my individual equity selection is unaffected by the behavior of crowds which we describe as "group stink".
My unemotional and opportunistic trading and investing style, at times, has and can benefit from this new regime of volatility. Nevertheless, the market remains challenging and, for now, I continue to view the return of capital as having precedent over return on capital. This helps to explain my 25% net long exposure.
At Seabreeze we are certain that attractive long opportunities will surface, we are less certain when they will surface. That said, we are starting to pick on the long side.
I am constantly on the alert for opportunity - especially when investors are losing their heads and acting emotionally - both on the downside and the upside.
My friend and former boss, Lee Cooperman (who was liberally quoted in last month's letter to Seabreeze investors and in my Diary), often says that opinions are like butts, everyone has one. So keep Lee's quote in mind, particularly when it comes to our short term market forecast (which follows)!
We have begun to add to our relatively low net long exposure in recent days. My sense is that developing long opportunities may be forthcoming over the short term. Perhaps, if the market's persistent decline continues, sooner than later!
In general I expect a "chop bucket" over the balance of 2022 with my baseline expectation that the S&P Index will trade in a narrow range of 3800-4250. (Precision of view is not intended.) With S&P cash currently at about 3910, an increased amount of equities have recently become attractive and candidates to purchase - even despite my broader market concerns, which, as I have noted, are slowly being discounted.
The true enemy of investors is dogma. As always, I will change my view if the circumstances and/or if my fundamental expectations change.
I am constantly on the hunt for high quality investments that can be purchased at attractive prices. But, smart investing doesn't necessarily consist of only buying good assets but of buying assets well. This is a very important distinction that very, very few people understand.
In his book How To Lie With Statistics, Darrel Huff wrote, "In a Bear Market, he who loses the least wins." So far so good for Seabreeze as we have performed well on a relative and absolute basis this year.
Looking Up, Not Down
"Both optimists and pessimists contribute to the society. The optimist invents the aeroplane; the pessimist, the parachute."
- George Bernard Shaw
As I have frequently noted, I fully recognize that shorts protect wealth but that longs generate wealth.
I look forward to continuing the process of slowly and incrementally positioning on the long side - as the market drops towards the lower end of my expected trading range. This more positive stance appears justified as some of the risks I outlined today are starting to being discounted ("second level thinking").
I am now looking up and not looking down.
(This commentary originally appeared on Real Money Pro on September 7th. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)