Happy Holidays and a Terrible New Year
2022 will be remembered as the turning point in a decade-long monetary and fiscal experiment that culminated in an epoch-defining orgasm of financial excess: thieves, charlatans, and scumbags of every colour and creed took to CNBC, the airwaves, and social media harping on some of the most stupid ideas ever concocted by our ape species - shitcoins, NFTs, SPACs, the triumph of J-curves over cash flows, community adjusted / compensation-excluding EBITDA, etc.
That this excess would collapse under the weight of its own stupidity is no courageous prediction, but the recognition that this pinnacle of excess represents merely the tip of an iceberg - an iceberg that has been agglomerating the lowest IQ / ethical points on our planet for nearly a decade and has only begun to be unwound - is an important recognition that we believe will define 2023, and perhaps beyond.
The catalyst is clearly the real cost of money, a concept so foreign to anyone under the age of 30 that it resides only in dusty history books and cranky market veterans - when capital was free, plentiful, and shoved down the throats of the financial system by central banks it was easy to delay recognizing the true costs of our collective mania and financial misdeeds. A multi-decade long trend of declining interest rates and a decade-long experiment in truly insane money printing / money supply expansion / central bank debt financing has not only stopped, but is being actively reversed. That bill is now coming due.
But don’t take it from us:
It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates. I consider it nearly impossible to overstate the influence of declining rates over the last four decades…
A recession in the next 12-18 months appears to be a foregone conclusion among economists and investors.
That recession is likely to coincide with deterioration of corporate earnings and investor psychology.
Credit market conditions for new financings seem unlikely to soon become as accommodative as they were in recent years.
No one can foretell how high the debt default rate will rise or how long it’ll stay there. It’s worth noting in this context that the annual default rate on high yield bonds averaged 3.6% from 1978 through 2009, but an unusually low 2.1% under the “just-right” conditions that prevailed for the decade 2010-19. In fact, there was only one year in that decade in which defaults reached the historical average.
It’s conventional wisdom that I agree with that stocks go up over the long-term - if you bought the DOW in 1929 you got back to even in 1954, the DOW was in 1966 where it was in 1982, when I look back at the secular bull markets in 82 we had a President who said government was the problem, not the solution, who fired all the ATC when they wanted a big raise… we now have a President who is a union man who says he’s trying to beat inflation who cheers a 24% / 3 year reward to the railroad unions, who thinks government is the solution not the problem… maybe more importantly if you look at valuations back then… the stock market was 50% of GDP, its now 150% down from 225% that’s because 5-years were at 15% when I started Duquesne so real rates were high that’s why we were at 8x depressed earnings, we’re now 18 or 19x inflated earnings that I have a very strong feeling will be down next year… then you had the secular forces, you were right on the initial ramp of globalization, a fantastic thing, building supply chains around the world increases efficiency causes disinflation, that’s been a trend for 20/30 years going the other way now, that’s going to be inflationary, and finally the last 10 years of the bull market you put it all in hyperdrive with $30 trillion of QE and zero rates, now the consequences of that are borne and all those factors that caused a bull market they’re not only stopping, they’re reversing - every one of them. We’re going from QE to QT… We’ve had a hurricane behind us for 30 or 40 years and its reversing and I wouldn’t be surprised, in fact its my central forecast, that the DOW won’t be any higher in 10 years than it is today.
I will be stunned if we don’t have a recession in 23, I will not be surprised if its not longer than the average garden-variety and I don’t rule out, not my forecast, something really bad. Why? If you look at the liquidity situation that has driven this, we’re gonna go from all this QE to QT, we’re following an asset bubble, we’ve been doing all this running down of the SPR which is now below 84 levels even though oil consumption is much higher, we’ve had a bunch of myopic policies that have actually delayed the liquidity shrinkage… QT has been almost entirely offset by Janet Yellow running down the Treasury Savings Account… she could’ve sold 10 years for under 1% but instead runs down the TSA, so all that has masked the liquidity shrinkage but it really comes into full gear but by the first quarter of 23 it goes the other way. So our central case is a hard landing by the end of 23.
Rates peaked in early Nov, down 90 bps since then, that doesn’t really help [the Fed], junk spreads down 150 bps since early Oct, that doesn’t really help the Fed, the 10 year Treasury down 50 bps, that doesn’t help the Fed - all these things being easier since then, obviously the stock market up since the 3600 low that doesn’t help the Fed… We don’t have co-ordinated tightening around the whole world - everybody tightening at the same time - too often, and we don’t have people telling me they’re going to go further tightening, and they don’t tell me where they’re going to go too often, and we don’t have 2 years below where they’re telling me where they’re going to go… and I understand that you got people saying inflation is down and that they should do this or do that, well they’re telling me what they want to do and they know all this stuff that all these other people do because they’re worried about this underlying mismatch in the labour market, they don’t want inflation to take hold and they don’t want it to get higher…
You should probably be less long… but for me, as a hedge fund manager, I’m going to lean short… I’m generally an optimist [but] I’m leaning short on the equity side because the upside downside doesn’t make sense to me because I have so many central banks telling me what they’re going to do… you had someone on your show saying they had a 220 earnings estimate for the S&P [but] why am I putting these really high multiples on these things, I have to put on realistic multiples… when we were talking 2010 the multiple was 11 or 12 coming out of 2009 and those rates, to get to this multiple now if you had 220 times 16 gets you to 3600.
The Fed says that they are going to get the job done - that means they are going to be hammering the economy, even just keeping rates where they are, and I think they are unlikely to stay on pause in February so you’re looking at another ratchet higher… the economy is going to weaken, I think that’s already happening on many fronts… nobody talks about M2 money supply anymore but the 6 month rate has gone negative so there’s not a lot of liquidity out there and making liquidity more difficult obviously is the Fed raising rates but people aren’t talking enough about QT, $95 billion a month - this is a lot, it hurts liquidity, it hurts the economy, its a headwind for the stock market, I’ve used for years the chart of the Fed balance sheet vs the S&P 500 and of course they deviate from time to time but the broad patterns are very clear to the eye, you don’t have to run a R-squared correlation, you just look at it and say look when the Fed shrinks the balance sheet it gets hard for liquidity and its a headwind for the stock market so I do think there’s a recession coming.
Frankly, you’d have to be insane to think that the the risk/reward in the S&P500 is currently skewed to the upside. Market expectations for S&P adj EPS in 2023 are 220 without a recession or slowdown - a near impossibility. A 10% decline in earnings on even a minor slowdown is entirely reasonable and conservative in light of the number of headwinds (many) and tailwinds (none) for earnings next year. Slap a 15 multiple on that and you get 3000 on the S&P 500. The risk of a recession being deeper or lasting longer than just one year? Reduce the multiple and earnings and you can envision a path to 2500 on the S&P (unlikely, but the skew is to the downside). Ask any Fortune 500 Executive and this economic slowdown is what they are preparing for. Even if they are being conservative, a co-ordinated contraction in spending, hiring, and investment by the world’s largest companies can become a reflexive / self-fulfilling prophecy for the economy (and markets).
All is not doom and gloom however. There are plenty of opportunities that we think will arise as we barrel into the Fed-induced economic storm.
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