Peak prices are in the rearview mirror, but not necessarily because the Fed is raising rates. It's the fear of a recession that is prompting demand destruction as businesses start to pull back the reins on spending as they fear an economic tumble in the months ahead. Consumers, on the other hand, appear to be hanging in there. U.S. retail sales rose 1% in June, despite record high gas prices in the beginning of the month. But if we factor in inflation, real retail sales are down 1.2%. That's the problem. Inflation may be waning but kind of slowly, and it's leaving some wreckage in its wake. All the Fed can do is keep raising rates.
Inside the stock market, trends keep on weakening. And now we've seen 34 consecutive weeks of more stocks making new lows rather than new highs. And that is taking the weed whacker to the S&P 500's earnings multiple, which is essentially a comparison of the price of the index compared to the profits of the companies therein. As of last week, the S&P 500 traded at 16 times its projected earnings over the next 12 months, down from 21.5 times at the end of last year, according to FactSet. That's a pretty severe haircut. But as you'll hear from Dan Niles, it may not be low enough.
Meet Dan Niles
Dan Niles is the founder and and senior portfolio manager for The Satori Fund. Previously, Mr. Niles was a managing director at Neuberger Berman Inc. and the chief executive officer of Neuberger Berman Technology Management. Prior to his career as a money manager, he also worked as a sell-side research analyst for both Robertson, Stephens and Lehman Brothers.
What's in This Episode?
Even with the big blow off the top of the stock market, there are unfortunately some pretty good reasons why it may not be over just yet. Growth rates are slowing. They had to eventually, and companies of all sizes are warning of more headwinds on the horizon. Inflation is doggedly persistent, and that puts pressure on companies and consumers. And then there's the Federal Reserve, which is committed to lowering inflation by any means necessary. And that means more aggressive rate hikes this year and likely into 2023. How this perfect storm is building on the investment horizon, and what it could do to the U.S. equity market, is something Dan Niles studies very closely, and his predictions for those outcomes have been pretty much spot on for his entire career. Dan is the founder and senior portfolio manager for The Satori Fund and one of the more astute market watchers and investors I've had the privilege of following for most of my career. And he is our very special guest this week on The Express. Welcome, Dan.
"You and I grew up with the expression 'don't fight the Fed.' In other words, if the Fed is raising interest rates, it's generally not a good sign for equities, at least in this part of the cycle. Is there any world in which that axiom will play out differently this time, or is this just one of those periods where we absolutely have to listen to these axioms and apply them to our investment philosophies?"
"Yeah, I think you have to imply that even more so today than in the past because for one simple reason, if you go back to the Fed... people use 'don't fight the Fed' typically in a positive way in that when they're stimulating the economy, you want to go ahead and take that into account and be long stocks, and that that makes complete sense."
"This time, though, I think the problem is the Fed's going to raise rates even as growth slows. So, in the past, they've typically helped buoy stock prices when you have a problem. So, you can think about the global pandemic as an example of that where, if you look at including dividends, the S&P doubled over three years, with two of those years having a global pandemic in them. So, that obviously doesn't make sense on its surface, except when you look at it and say, 'The Fed went ahead and put in $4.8 trillion in stimulus following COVID-19. And on top of that, you had $5.5 trillion of stimulus from the U.S. government. So, you can think of it as $10 trillion in stimulus going into the global economy.' And to put that in perspective, U.S. GDP is only about $20–$21 trillion in size. You literally pumped in 50% of GDP into the economy over a two year period of time, and that's what made stocks go up."
"This time, though, with growth slowing, the Fed is going to actually keep pushing to drive down... even more because they've got the highest inflation in 40 years. So, unless you were investing back in the 1970s or you studied the stock market in the '70s, early '80s, you have no idea how ugly this can get because the Fed, instead of trying to help prop stock prices up, is actually going to focus on driving economic growth slower to get inflation under control, which is the number one thing they're worried about at this point."
"The risk, of course, is that they put the economy into a deep freeze, into a recession. You noted that the GDPNow tracker that the Atlanta Fed has shows negative growth already for the second quarter, which just ended. So, either we're in a recession already, or we're about to tip into a recession. Add that to the fact that we have this sticky high inflation. Rates, of course, are rising. Which of those evils should we fear the most, or is it just the hydra of all of these things happening at the same time, the perfect storm, that is more terrifying?"
"Yeah, I think, Caleb, you expressed it well. It's the hydra, and I love that term. It's all of these things. You can't just focus on one because the economy isn't driven by just one thing. As you rightly pointed out, it's the combination of the Fed being very aggressive. It wouldn't surprise me for us to get 100 basis point rate hike later this month following the 75 we just got. Obviously, economic growth is slowing on top of that. You've got issues with the war, and that continues. So, it's really all of the things, as you pointed out."
"We haven't had this type of a perfect storm in quite a while. Of course, the onset of COVID-19 was a black swan and shut everything down. But all of these things coming together... You're forecasting now a 30% to 50% drop for the S&P 500 from peak to trough. We're now down around 20%, 22%ish. So, from your perspective, we could fall an additional 10% to 30%, which could all play out into 2023. Why do you think we'll see that much capitulation, Dan? There's a lot of passive money in the stock market that hasn't done anything."
"Absolutely. Well, I'll give you the simple math. So, there's only two things that determine the level of the stock market. There's earnings, and then there's the multiple you'll pay for those earnings. So, if you look at those two things separately, right now, consensus is for 2023 S&P 500 EPS to be about $250. If you go back and you look at prior recessions, I think saying, 'That's going to be revised lower by about 20%,' is reasonable. So, that gets you to a $200 EPS estimate. What market multiples should be... right now, the trailing S&P... and I use trailing because as I said earlier, we think the forward numbers are going to come down... and so if you look at history using trailing numbers, those are the only numbers you know are real. That's what's already been reported."
"And so, if you look at trailing P/E, you've got an estimate of about 19 times on the S&P 500. Now, in the past, when inflation or CPI has been above 5%, that trailing P/E ratio is 12 times. We're at 19 today. If you want to be incredibly optimistic and say, 'We're going to get back down to 3% by 2023.' Above 3%, the S&P trailing P/E is 15 times. We're at 19. So, that's why I say if you apply... let's be optimistic, and say we're going to get inflation back to 3%. Use a 15 P/E, which is average, and you do that against a $200 EPS, you end up with about $3,000 on the S&P 500 versus about $3,750 or so where we are at this moment. And so, that gets you into that range of down 30 to 50. And quite honestly, it could be quite a bit worse than that because typically during market corrections. You overcorrect just like on the upside, as we saw with meme stocks and Bitcoin and everything else. When the Fed was pumping money into the economy, things overshot to the upside."
"So, we'll have to see how this plays out. But my feeling is the bottom is somewhere in 2023, when the Fed's done raising rates, when economic growth has really slowed down. And that's when you want to say, 'Okay, we can go back into the stock market.' Until then, my view is, for the average investor, you're just better off staying in cash, losing 6% to 7% to inflation then you are losing 30% to 50% to a correction in the stock market. And that's pretty much what we've been saying since the beginning of the year to, you know, cash is probably our favorite investment for the average investor for that reason."
"Right. A lot of other investors will say cash is trash because of inflation and because you're losing money basically holding on to it. But if your philosophy... if your thesis is correct, I should say, then your losses will be a lot less than another 15%, 20%, 30% down in the S&P 500. But then you position your portfolio daily to minimize losses and chase alpha. You're a professional investor. Most investors, most of our listeners, we don't do that. We're passive investors, we're index fund investors, maybe we have ETFs, but what can we do if we're not going to rotate and go to cash right now completely? What can we do to minimize the pain that a lot of folks are experiencing? Because we didn't rebalance, we didn't rotate, we didn't reallocate. We didn't reposition our portfolios for this change in the seas back at the end of 2021."
"You're not going to like this answer, but I don't think there's a lot you can do unless you're willing to be short the market. And that's a dangerous proposition, as people saw with the meme stocks, etc. So, if you can manage your portfolio daily and you are very good at taking emotion out of your investing process, then I think you can make money in this market. And that's quite honestly something we've been very good at because... my background's an engineer by training, I have these 20 or so technical metrics I use to try to protect me from myself really."
"Because typically, when markets go down a lot... we're human beings, right? We're wired to stop pain and to embrace pleasure. So, when it's going straight down, that's when people are typically selling and when it's going straight up, that's when people are typically buying. And quite honestly, you want to be doing the reverse. So, I think if you are comfortable buying into the teeth of a massive drawdown that, on a technical basis, looks oversold, you can go ahead and do that and make some pretty good money. And we've talked about this and we've got some of this written up on our website at danniles.com, but we talk about the fact that some of the most vicious bear market rallies are between 18% to 21% in size. That's what you saw during the global financial crisis and the tech bubble breaking. If you think about that, five rallies of 18% to 21% in the S&P 500, and you're losing 50% roughly of your money in both of those episodes."
"And so, that's really the only way to be able to effectively make money during this environment, because right now bonds are a problem, obviously, with inflation where it is. I think stocks are a problem for the same reason. But really all asset classes, you're not sure where that $10 trillion in money that we talked about earlier, between the Fed and the U.S. government, where that ended up because some people went out and they bought stocks, others bought homes, others bought crypto, others bought meme stocks, art, or wine, you name it. It's gone into all these different categories, and so when that money gets removed, all of those categories go down. And so really, unless you're willing to bet the prices for pretty much everything drop, you can't really make money in this environment."
"You make a great point. But also, as you know well from watching these cycles, some of the best performing days in the S&P 500, the stock market overall, are during these bear markets because that's when you get these 2% to 3% bear market rallies or bull traps or dead cat bounces, whatever you want to call them. So, if you sell everything or you start selling out of your portfolio, you miss those little mini blip recoveries, and it just set you back a little bit farther from recovering back to par in your portfolio. Does that rule not apply anymore?"
"No, no, that does apply, and sorry if I didn't state that clearly. But if you look at our Twitter post, for example, you'll see that during this year, multiple times we said, 'Look, based on our technical metrics, it looks like the market is hitting a short-term oversold condition. We expect a bear market rally,' and we've gotten those already this year. That's very, very typical. And so, what I'm trying to say is the hope would be, if you want to try to make money, buy when things are oversold. But then don't confuse that rally with, 'Oh, everything's all clear. Everything's all good,' because it's a bear market trap."
"And the way to know if it's a real rally that'll continue or we're in the next up cycle is are corporate estimates looking like they're stabilizing and not getting cut? Is the Fed close to being done with raising rates? And one good judge of that is where is inflation or CPI? If you don't have those three pieces between fundamentals, the Fed, and inflation obviously driving the Fed at levels that make sense, then you should assume that's just a bear market rally and sellout after you get the typical move higher. And by the way, the statistics on those moves higher are you typically get back about 70% of what you have lost on the prior leg lower or that tends to stall out. And that's just a rule of thumb. Twenty-five percent on the move, you gain back over 100% of the prior move lower before it started to go down again. But I use 70% as a good average over time, looking at prior bear markets in the past and how much they've been able to bounce."
"Great advice. And I was going to ask you, 'How do we know in the coast is clear?' But you just told us what to look for to find out if the coast is clear. So, then what, Dan, are the characteristics of the companies that will make it out of this period the strongest? And in what sectors are they operating in?"
"That's a great question because the key is to survive this and to pick the best on the way back out. I think you need to go back to the basics. And during the bubble, whether it was a tech bubble back in 2000 or the global financial crisis or most recently with what we saw when the Fed pumped all this money into the economy, people didn't really care about things like, 'Oh, is the company making money? Are they generating a lot of cash flow? How long is it until they can make money, and how many competitors do they have?'"
"And so for me, the big thing I focus on is will a company be able to survive if you go into a deep and long recession? And the only way you can survive is if you have cash on the balance sheet. You're generating cash because without that, you may be one of those names that goes to zero. Amazon's a great example that I bring up where, if you go back to 2000, the stock at one point peaked at about $106 a share and they were growing over 230% coming in to that 99 period. And then that growth went to 0% revenue growth. Zero at its low point, and the stock went from $106 to $6. But the revenues actually doubled almost from $1.6 billion to $3.1 billion over that couple of year span of time. But they managed to survive."
"There are, roughly estimated, somewhere around 4,000 Internet companies that went under during that two year span when things were collapsing. Amazon survived, and they made it out, but they were very focused on expanding their markets and growing, and they showed that they could actually make money if they wanted to, but Jeff Bezos reinvested all those profits. A lot of the companies today, they can't make money if they want to. They're stuck spending a ton of money and they're not going to be profitable till five to 10 years from now. And so, that's a big problem because you're not going to make it out of this when every company that's looking a decade from now needs capital, they're not all going to get funded."
"So, that's a long explanation, but I think those are the keys that you want to look at: cash flow generation, profitability, size of market, growth of end market. And then the final piece is 'what's the valuation?' Because if the valuation's too high, you're not going to be able to make it back if it resets. Cisco's a great example. I think most of your viewers probably know the company. The stock's still not back to where it was in the peak at 2000. And you think about that, and you go, 'Wow, Ciena's another name.' Public today, public in 2000. Revenue's up significantly. Stock's nowhere near that. And obviously networking has grown a lot. Right. Internet's huge, as everybody predicted. But these companies are providing some of that plumbing. Stocks are nowhere near where they were in 2000. That's I think the thing you want to focus on, the final piece, is valuation."
"What's the one thing, Dan, that nobody's talking about that we should be focused on or that you're worried about that's not making the headlines, like every-day inflation or the fact that the Fed's going to raise a basis point three quarters, whatever. What's nobody talking about that you're also a little bit worried about in the back of your mind?"
"I think the big thing is I'm waiting for something to break. And what I mean by that is, there was a lot of money, as I said earlier, $10 trillion, pumped into the economy over a couple of years. And that's just in the U.S. That's not including what was happening overseas. And so, a lot of that, unfortunately, people use to speculate. And when you've got these massive drops in things like cryptocurrency, I think a lot of your viewers are probably familiar with, and everything that happened with Luna. And now you've got crypto hedge funds and firms going to zero, and some of them were leveraged."
"There's other stuff out there that this is happening to. We just don't know where it is. And it's not going to surprise me if some time before the end of this year we hear of a Lehman Brothers type moment, and it might even happen in a country. Some of your viewers may remember in 2010 we had the sovereign debt crisis going on in Europe. Right now we've got some developments going on in Europe that should scare people with what's going on in Italy, for example, where their spreads are starting to blow out. The credit markets are not behaving well right now. And I always joke that the credit market investors are a lot smarter than equity investors because equity investors care about return on capital. Where they're going, 'Oh, if I put money into this crypto, how much can it go up?' Credit investors are concerned with return of their capital. 'Am I going to get back the money I invested in this debt, in this credit?' And so, they're very focused on things like solvency, entity risk, etc."
"And so, when the credit markets start to act strange like they did before the global financial crisis, like they did back in 2000, that gets me very nervous because up until now, you've had a lot of people that have said, 'Well, I'll own, let's say, 60% in equities, 40% in bonds. And when my equities drop, then people will go buy bonds because bonds are safe.' Well, if you look at this year, we've had like the worst start in both equities and bonds in something like 40 years. And so, when you look at that environment, you know that there's entities out there that thought they were... the 60/40 portfolios and that they would be fine in an environment where stocks got hit like this, but they're getting just absolutely obliterated in their bond positions, which they thought were actually pretty safe. And they might have levered some of that up to get better returns because it's 60% in equities, 40% in bonds. And so, to get the equity type returns, you lever up that portfolio and that's generally worked okay for the last 40 years because rates have continued to drop. So, those are things that I don't think the average person is spending a lot of time thinking about but which scares me because during these big drops in the market, over time, something is typically broken, and that's really what scares me."
"Yeah, it's a great point. Let's go out on this. We ask all of our guests, especially our black belt investors, for their favorite investing term. What's the term or definition that just speaks to your heart, Dan? That makes you sort of love what you're do, or when you see it, you just gives you a smile every time."
"I think alpha's the main term that I really love because anybody can generate eye-popping returns during a bull market by taking on a lot of excessive risk. But those same people are going to lose a ton of money when that turns against them. So, you have a really great definition on Investopedia on alpha. And I think just my quick summary would be, can you generate returns in excess of the market returns? And a big portion of that is can you protect capital when the market goes down, and then can you outperform or fetch more than your fair share when the market goes up? And so for us, that's how we judge ourselves. And we look at things like the hedge fund return index, which is obviously the index I benchmark to, and how we've done over time. And you've almost doubled the return of that HFRI index over an 18-year period of time by really protecting when the markets get ugly."
"And so, to me, that's how I focus on generating alpha. I live in California, obviously, and I always like to say, 'There's a lot of ways to put points on the board.' Stephen Curry, unbelievable player. Obviously the way he scores is very different than the way Shaquille O'Neal scores. But they both generate excess returns over what the average basketball player does, and they each have their own style. And I think that's the thing that an investor should think about is, 'I'm 5-foot-11 on a good day. I'm not going to be playing like Shaquille O'Neal.' So, for an investor, if you're comfortable with value investing, then that's what you should stick to. If you like taking on more risk, that's fine. But then remember to marry that with, 'Well, where are valuations?' And be comfortable getting out of some of that. If you're a credit investor, then similarly try to stick to your knitting, but try to marry all of those things together so you can generate alpha over time. And so, for me, the number one thing I try to focus on is alpha. And I think you have, as I said before, a great definition on your page. People should go read it."
"Thank you very much. And we love that term as well. We're going to add a quote from you into that term just because it's so special to you, and you've been such a an important person for me to follow as an investor throughout my career. I've learned a lot just by watching you and reading your stuff. And we're going to link to Dan's research at danniles.com. But check out what he does. Follow him on the social media platforms. Dan Niles, the founder and senior portfolio manager for The Satori Fund. It's been a real pleasure to have you on The Express. Thanks for joining us."
"Been an honor to be on. You have a great website. Great information. I go and use it myself from time to time. So, pleasure to be on."
Term of the Week: Margin Call
It's terminology time. Time for us to get smart with the investing term we need to know this week. And this week's term comes to us from Lance in Thomaston, Georgia, just south of Atlanta, as Brett Cobb likes to sing. Lance suggests margin call this week, and we like that term not only because we love the movie Margin Call, but it's pretty appropriate lately given the steep sell-off in stocks and cryptocurrencies and what that means for investors or traders who levered up to buy those assets.
Well, according to my favorite website, a margin call occurs when the value of an investor's margin account falls below the broker's required amount. An investor's margin account contains securities bought with borrowed money, typically a combination of the investor's own money and money borrowed from the broker. A margin call refers specifically to a broker's demand that an investor deposit additional money or securities into the account so that it is brought up to the minimum value known as the maintenance margin. A margin call is usually an indicator that one or more of the securities held in the margin account has fallen in value. And when a margin call occurs, the investor must choose to either deposit additional funds or marginable securities in the account or sell some of the assets held in the account.
We're seeing an increase in margin calls in the equity market, but they are spreading like poison ivy in the crypto market as well. Three Arrows Capital, a crypto hedge fund based in Singapore, was the first prominent fund to collapse after failing to meet its margin calls a few weeks ago. And it likely won't be the last as many crypto brokers, miners, and investment funds did some heavy borrowing using Bitcoin as collateral. Smart suggestion, Lance. A pair of socks are coming your way.