Summary – Fed Minutes Citing Valuation & Stubborn Inflation Argue for Safety
We expect more negative macro news to drive further equity sell-offs, and expected lower equity valuations to build positions in equities we like, particularly high growth, high-beta, especially tech stocks.
We are looking for “the other shoe to drop.” Restating, we are looking for macro data showing higher unemployment and increasing supply of housing, along with lower prices in real estate, combined with large equity price declines. At that point, we want to put make large investments in our favorite names.
Quick Comment – Love AI on Expectations of Rapid Commercialization & Adoption
Our view is that Artificial Intelligence has clearly reached a technology inflection point. We expect wide-spread rapid development and commercialization of AI. We predict that this will result in dramatic and pervasive changes in work processes, and accompanying opportunities to enjoy 10-times returns on the equity of the winning companies.
AI in 2023 appears analogous to the Internet around 1997, or crypto around 2009. There think that there will be a short-term rising tide effect, lifting all AI-equities, followed by sequential years-long cycles of growth and contraction. Early leaders that maintain their market leadership will appreciate astronomically. Second and third-wave technology leaders can also offer massive equity appreciation. Underlying enabling technology leaders will enjoy long-term earnings boosts. Plenty of money to both make & lose.
So, what data is next?
Aside from the usual spate of regular weekly unemployment data, and monthly housing data scheduled for the first week of March 2023, the following are major macro events.
- February 25, 2023 Warran Buffet’s Annual Shareholder letter.
- March 16, 2023 is the next ECB press conference after the Governing Council meeting.
- March 21-22 is the next Federal Reserve Meeting, which includes a release of Summary Economic Projections.
- March 31, 2023 the next PCE release.
- Beginning of April – unofficial start of earnings season, with (4.3) EPS expected, accelerating decline, and slowing sales. I/B/E/S Refinitiv.
- April 27, 2023 is the U.S. GDP advance estimate.
ANALYSIS: MACRO SEEMS TO BE DRIVER OF EQUITY
January 2023’s 0.6% monthly/5.5% annual increase in PCE Highlights Valuation Conundrum
The conundrum in macro data makes investment seems to have created a consensus that investment decisions are unclear.
On February 23, 2023, the U.S. Federal Reserve issued its January 31-February 1, 2023-minutes. Those minutes noted that coincident data, meaning data metrics of current conditions, is strong: “historically low unemployment,” “moderating inflation.” However, those minutes also reflected practical realities: inflation remains “stubbornly high,” and “measures of valuations in both residential and commercial property markets remained high, and that the potential for large declines in property prices remained greater than usual…the forward price-to-earnings ratio for S&P 500 firms remained above its median value despite the decline in equity prices over the past year.”
On January 30, 2023, the International Monetary Fund reported that “inflation is peaking amid slow growth” and “global inflation is expected to fall to 6.6 percent in 2023 and 4.3 percent in 2024, still above pre-pandemic levels.”
So, we tend to think major Central Banks will rise further than markets expect, faster than markets expect to impede growth as a tool to curb inflation. This creates risk of lower equity prices. However, we are buyers of tech and growth, at a certain point.
1Q2023 Market Earnings Expectations are for Declines, But We Don’t See Massive Equity Overvaluation.
As of February 24, 2023, I/B/E/S data from Refinitiv reported that 1Q2023 aggregate S&P earnings were expected to be negative 4.3, and negative 6.2, excluding energy, on 1.4% annual sales growth. These figures compare to negative 3.2, and negative 7.4, excluding energy, on 5.7% annual growth, for 4Q2022.
I/B/E/S Refinitiv reports that the 4-quarter forward aggregate S&P500 P/E ratio is 18.1x.
Conventional wisdom that 18 is high valuation, historically. It is, if looking at a 140-year chart. However, “eye-balling”, the February 23, 2023-Yardini Research, Inc. forward S&P ratio shows a range between approximately 12 and over 20.
Bottom-line on public equity valuations, we do not think that overvaluation, alone, will be the catalyst for equity sell-offs, but if equity sell-offs occur, valuation can be a reason to buy.
Anecdote: Co-Star Reports that Columbia Property Trust Defaults on $1.72 Billion Loan
As a data point showing the negative impact of loan interest rates materially higher than in the past decade, Columbia Properties Trust, a large owner of commercial real estate with high profile tenants like WeWork, Twitter and SnapChat has defaulted on $1.72 billion loan.
So, this supports our thesis that we need to “see the other shoe drop,” to call a bottom on equities.
Conclusion
Since late-Spring 2022, we’ve been saying the same thing. We need to see macro data show higher unemployment, more housing supply, and lower prices, corresponding to steep declines in equity prices to call a bottom. We expect these to occur in 2023.
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