Waiting to Cross

July 8, 2022

There just isn’t much clarity these days. The three things we look for . . .

The numbers.

The narratives.

The nerves.

They’re all a jumbled mess. We’re all a mess, as we collectively stumble and fumble around, figuring out if this will turn, and by turn we mean for the better . . . for our positions. Most investors are down this year, it’s hard not to be when the S&P 500 has shed ~20% and the once high-flying NASDAQ ~30%. Many investors have probably not even opened their statements because “knowing knowing” sure hurts more than just vaguely knowing.

As we dive into the second half of the year, we’re at an intersection. Look to the left and investors are holding signs screaming for “MOAR GROWTH”, since all will be well, inflation will abate, the Fed will tame it, and growth and all its hanger-ons (e.g., SaaS companies, tech companies, bitcoin, crypto, etc.) will reassert itself.

Look to the right and we have the fixtures of every city sidewalk, the Doomsdayers. The prophets with their perpetually cheerful message of “THE END IS NEAR!” If extremists seem to always get the attention, they do, because well . . . they’re so extreme. Since behavioral economics teaches us that fear is twice as powerful as greed, we can’t help but pay attention.

Look across and we see the “STAGFLATION!” crowd, the listless dudes with little purpose. Is it ennui or just defeatism? What’s the point man? Low/no economic growth coupled with high inflation will persist for years man. Bro, we’ll all need to globally sort through our issues of public/private over-indebtedness, structural undersupplies of commodities, and eroding institutional credibility (be it political, judicial, or financial). So we’re definitely not going anywhere for awhile.

Then there’s us. Our sign? It’s blank. If pressed we’d probably put “???????". It’s confusing because as we stand at this intersection watching each group yell at one another, we can’t help but wonder A) how are these people positioned in their portfolios and B) how can they be so certain? More accurately, we’re also wondering if they’re all right . . . to some extent.

Confusion Reigns

Greg Jensen at Bridgewater describes it as “cross-currents,” and we think that’s an apt description. We may have a core structural thesis (XYZ will go higher or lower because of what you believe), but you can get hit from many different sides when there’s so much uncertainty.

We’ve been heavily invested in commodities for the past few years, and our positioning hasn’t changed much. The thesis was fairly simple. Pervasive underinvestment meant a structural shortage was brewing. Sounds easy, but as inflation increased post-COVID and post-Ukraine invasion, the financial markets took commodities for a spin, looking for hedges and a safe haven. Since then, it’s been all about the macro (i.e., the bigger picture and where the market thinks the global economy will eventually go).

The financial trading of oil dominates the physical. For every “real” barrel of oil changing hands, about 30 “paper” barrels are traded. So in the short-medium term, oil, and many commodities for that matter, can become the market’s chew-toy if inflation’s the topic du jour.

Hence our focus on the macro picture as opposed to the micro (counting barrels and looking at the fundamentals of the oil companies). As the Fed’s become increasingly aggressive about taming inflation, raising rates (to make “money” more expensive and thereby decrease demand/inflation), the market (particularly those on the Moar Growth corner) has given them the benefit of the doubt. The US dollar has strengthened considerably, and inflation expectations and interest rates have come off their recent highs.

Growth investors are thinking yeah, if the Fed pivots aggressively now, they’ll get ahead of inflation, and even if they don’t their actions in tightening liquidity will drive this economy into a recession, which decreases demand and inflation anyways. Tails we win, heads we don’t lose. Translation? Moar Growth! . . . as investors in that corner of the intersection pile back into tech stocks. Just look at the recovery in the growthiest of the growth, bouncing off a $36 low.

The market is forward looking, so maybe their protest song isn’t so wrong afterall.

“Blue skies,

Smiling at me,

Nothing but blue skies,

Do I see.”

Why Sinatra? Who knows. Here’s looking at you kids.

In contrast, the Doomsdayers? Well they’re posting charts like this.

Consumers, who power 2/3rds of this economy, have never been so depressed, and if we’re not already in a recession, we’re about to head into one as indicators like the 2 year / 10 year Treasury spread which has and we quote “always preceded a recession” invert.

Besides, GDPNow, the Atlanta Fed’s own contemporaneous measure of the economy is also flashing “blah”.

No wonder commodities prices are falling . . . there’s just no demand, again indicative of a slowing economy.

In fact, according to them it’ll get worse because unemployment claims are now trending higher, mortgage applications are down, and consumer appetite for any large purchases (be it house, car, or appliances) are in the doldrums. While the Moar Growth crowd is getting a bounce of late, Doomsdayers all agree that they’re living in a fantasy land and on borrowed time. Inflationary headwinds coupled with consumer malaise means corporate earnings have to fall because if costs are increasing year-over-year and people are pulling back on spending, how can this (i.e., increasing corporate earnings) even happen?

Per Crescat Capital, during the 1960s/1970s when inflation flared, corporate earnings subsequently declined 30%. Today’s 12 month forward looking P/E ratio is 17x, what happens when the “E” begins to fall as margins decline? If not 30%, certainly 10% seems reasonable given the 8.6% year-over-year inflation we’re experiencing. Said another way . . . there may be more market pain to come because some people are still staring at Blue Skies.

Sooo . . . The END IS NEAR?

Ugh! Adulting is so hard.

Perhaps the desire for things to continue is just so strong that it overcomes the headwinds. Despite the seeming obvious signs that things are more expensive and that there isn’t quite enough stuff, everything could still be okay. Maybe Moar Growth is right.

Yet, how do asset prices appreciate as the Fed drains liquidity from the system; don’t the rubber duckies all have to fall in value? Furthermore, how do stock prices climb if earnings begin to erode from the unrelenting inflation? As much as we like the Moar Growth crowd, doesn’t it all seem a bit dicey? They want to believe that the Fed’s our Catcher in the Rye, that they’ll figure it out, and hey, even if they don’t get it precisely right, they won’t be directionally correct. Hmmm, sure is a lot of hopes and dreams there. Thoughts and prayers to you.

Still hopes and dreams can suspend disbelief far longer than you think. In fact, it could last for months, particularly as the market watches how inflation plays out now that the Fed is on the case. Toss in the possibility that the Europeans could pressure Ukraine to negotiate a ceasefire as natural gas stores reach critical levels ahead of winter, we could very well see the market rip higher in the interim.

Inevitably though, reality intrudes. Structural commodity shortages are still shortages, and despite the financialization of the market, we’ll still need “stuff” and that stuff gets more expensive as inventories dwindle. Thus, inflation continues and rates get hiked. If so, it may be the Doomsdayers’ turn to cross the street. If the deteriorating economy, higher rates, and evaporating liquidity doesn’t sap your market multiples, eventually declining earnings will.

Down we go.

Afterwhich, is it the Stagflationists’ turn? An economic malaise that persists? Low/no growth man, what’s the point, it’s all hopeless. Bummer.

So we’re standing at the intersection looking at everyone and thinking, maybe they’re all going to be right, but just at different times. It’s not a binary issue whereby each corner is right or wrong. Everyone’s just waiting for their turn. First the Moar Growth, then the Doomsdayers, and finally the Stagflationists. Maybe we don’t have to head left, right, or center, maybe they’ll all just get their time in the sun.

Maybe . . . maybe being confused is okay because it allows us to just sit back and wait.

Everyone’s free to move about too, but we know many won’t. We know when times are scary, when things uncertain, the natural instinct is to stay and shelter-in-place. They’re all entrenched in their positions these days, certain in their beliefs during these uncertain times.

That’s fine, we understand. We’re just as confused and uncertain as everyone else, standing here at the corner thinking . . . how do we cross this street again?

Ugh. Adulting IS HARD.

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