Fri, Jul 21, 2023|Whitney Tilson

Doug Kass: Why I Am Bearish Over the Remainder of 2023; First day of our Backroads trip

1) In yesterday's e-mail, I quoted from my May 4 e-mail, in which I shared how my friend Doug Kass of Seabreeze Partners joined me in nailing the bottom of regional bank stocks that day – recommending PacWest Bancorp (PACW) and Western Alliance Bancorp (WAL), which are up 155% and 275%, respectively, since then.

But I don't always agree with Doug... like today, when I remain moderately bullish on stocks for the rest of this year, while he has turned bearish. Since I like to share smart opinions that are contrary to my own, here's Doug's recent missive laying out his concerns...

Why I Am Bearish Over the Remainder of 2023

In the body of this missive I explain my view that downside risk dwarfs upside reward.
Today, few stocks meet my standards for selection.
We see short- and longer-term challenges to equities.
"Slugflation" – sluggish economic growth and prickly inflation – may lie ahead.
Equities are particularly overpriced relative to interest rates – the equity risk premium is thin and bond yields are very high relative to the S&P dividend yield.
The secret to making money in extreme times of high valuations lies in contrarianism, not conformity.
I admit to having been wrong over the last few months and may continue to be wrong...

What follows is a compilation of some of my Real Money Pro articles over the last month combined with a recent letter to my investors at Seabreeze – which outlines my ursine market views...

It is easy to forget that I started the year more optimistic than the consensus, expecting a mid- to high-single-digit percentage return for the S&P Index. It is also easy to forget how negative most market participants were in early January. Apparently, many of those bears – who were mostly bullish last year – parading in the business media, have even forgotten their earlier views!

Through the first six months of 2023, the markets achieved our forecast and much more.

As the market continued to advance over my projected "Chop Bucket (3700-4100)," I positioned my portfolio net short – in the belief that risk exceeded reward.

As I recently mentioned in a Bloomberg interview, there is nothing more humbling in the investment management business than positioning bearishly in a bullish move.

The art of investing is at times more like wrestling than dancing – such was the case in the last two months as I wrestled with the Bull.

We were surprised that equities continued to mount a sharp advance in price in the face of emerging global economic weakness, corporate profit uncertainty, sticky inflation, the lack of global cooperation between the world's leading economic powers, a massive debt maturity wall, and still narrow market leadership (which was dominated by 7-8 large-cap tech stocks). The lopsided leadership is illustrated in the following two charts:

Even more surprising to us was that valuations expanded in the face of a continued rise in interest rates and with growing evidence that U.S. monetary policy will keep interest rates "higher for longer."

We also underestimated the animal spirits and fear of missing out (FOMO) in a market that is dominated by passive products and strategies that are directed by algorithms and machines that base their decisions principally on price momentum. As we have stated in the past, the dominance of passive investing has led to exaggerated price moves as price momentum is prized and embraced – with buyers living higher (and sellers living lower).

As we will discuss further in the body of this letter, with interest rates now expected to be higher for longer, it is difficult to see a favorable reward vs. risk for equities:

The P/E ratio of the S&P Index (excluding technology/AI) is above 18x, well above the 15.5x to 16.0x average over the last five decades.
The equity risk premium is thin – and growing thinner.

The S&P dividend yield is only 1.50% compared to the yield on the one-year Treasury note of 5.40% – that's the largest gap in decades.

Liquidity is declining as the Fed is likely to stay "unfriendly" and tighter for longer.
Budget and current account deficits continue to expand and will have to be funded by large holders of bonds who are already overweighted in bonds and are nursing losses.
Equity investors are positioned far more aggressively today than at the beginning of the year.
We view the recent move higher in stocks as an overshoot with few stocks meeting our criteria for long purchases. We continue to view equities as generally unattractive, with upside reward being dwarfed by downside risks.

We invest dispassionately, by evaluating reward vs. risk with a strong dose, standard and requirement of a reasonable "margin of safety." The key to investing at times that equities appear to be overvalued (as today might be the case), as well as investing at times when equities are undervalued, is, as Rudyard Kipling wrote in the poem "If" – is to "keep your head when all about you are losing theirs."

Investing results should be evaluated over cycles and not over arbitrary calendar periods. Being wrong for a brief period of time is normal and should not scare one out of the game or change the approach to analyzing markets and companies as well as evaluating opportunities.

What is important is to manage risk properly when wrong.

Before we start our brief assessment and critique of the markets, we wanted to emphasize that we strongly recognize American exceptionalism – the belief that the United States is distinctive, unique and exemplary compared to other countries around the world.

We also recognize the tendency for equities to rise over time – and that, as such, long positions serve to generate wealth while, when appropriate, short positions protect wealth.

Nonetheless, when we evaluate the business cycle, inflation, interest rates, fiscal and monetary policy, the U.S. corporate profits outlook, and other factors, we remain of the view that equities provide little value at current levels.

Thinking about the macro environment and how it influences our proper risk posture falls squarely within our responsibilities as an investment manager.

As noted last month, the global economy and U.S. corporate profits face an abundance of short-term headwinds.

The Federal Reserve faces a trilemma – the challenge of simultaneously reducing inflation, minimizing the hit to economic growth and jobs, and maintaining the stability of the financial system.
There is growing evidence that inflation will remain persistently high, particularly relative to the Federal Reserve's target.

The rally in risk assets also should induce the authorities to maintain tighter financial conditions than seen by the consensus.

We expect interest rates to stay lofty. We do not expect the Fed to lower the fed funds rate in 2023.
Corporations will likely face an extended period of higher costs for servicing their debt.
Corporate taxes are likely headed higher.
Globalization is being reversed, spelling higher cost of goods for many companies.
We are of the view that domestic and global economic growth will slow significantly over the balance of the year, reflecting the lagging impact of higher interest rates and increasingly restrictive bank credit availability.

Multiple short-term challenges (above) suggest that a further broadening out in market participation with important groups such as cyclicals, energy and financials, may be difficult to achieve.

Looking longer term, the headwinds and challenges are equally as robust:

A mountain of public debt and a continuing and out-of-control U.S. deficit.
Our political leaders on both sides of the pew show no inclination to be disciplined in controlling our nation's fiscal spending.
The likelihood that inflation will be difficult to arrest.
The failure of policy to address supply issues of important commodities, especially oil.

The absence of cooperation between the world's economic powers.

The growing probability that interest rates and the cost of capital will remain elevated, placing pressure on corporate profitability and stock valuations.

The end of globalization augurs poorly for the secular trend in corporate profit margins.

"Bear in mind that much of what happens in economies and markets doesn't result from a mechanical process, but from the to and fro of investors' emotions. Take note of the swings and capitalize whenever possible." – Howard Marks

Increasingly, in the business media, we are beginning to hear the word "Goldilocks"... again as confident bullish "talking heads" – who know everything at price but little about value – predict new market highs this year.

Many, compromised and influenced by the strength of the rally, are now growing indifferent to the trends in interest rates, corporate profits, global economic trends, the geopolitical headwinds, and expanding valuations.

But, disregarding these factors has, historically, been harmful to one's investment health – and the current bout of confident optimism is the sort of condition and emotion that appears in maturing bull markets.

The relationship between stock prices, earnings, and interest rates is particularly important as the equity risk premium is the foundation of stock prices and rates and profits are the anchor of discounted cash models.

The equity risk premium clearly signals that credit is more attractive than equities and that stocks are overvalued. And so, according to the ERP, either stock prices or interest rates should fall. Unfortunately, interest rates at most maturities have been rising for more than a month, and the pace has recently accelerated.

Since the October 2022 lows, P/E ratios have risen from about 15x to over 20x (a gain of +33%), while inflation-adjusted interest rates, as measured by. the 10-year Treasury bond yield, are at a multi-year high of close to 1.60%:

To add a cherry to our more bearish sundae, the gap between the S&P dividend yield (1.50% today) and the one-year Treasury note yield (5.4%) is at a multi-decade wide. Again, like the above factors and as momentum intensifies to the upside – these rate observations serve only as "noise" to the ebullient momentum chasers.

As illustrated in the balance of our commentary, with inflation still higher than desired, unemployment low, wages still rising, corporate income statements and balance sheets strong, equities advancing, budget and current account deficits still too high, and real rates still not high – the implementation of policy may be problematic for the markets.

Interest rates, as we have noted, are likely to stay higher for longer.

Remember, keeping rates at high levels for longer is a continued form of monetary tightening as each day that passes someone' s adjustable rate mortgage resets much higher, someone's commercial real estate debt is coming due at an interest rate on offer more than double on the loan that is maturing, some businesses debt needs to be refinanced also at a much steeper rate, and some projects or businesses don't get started because more equity is needed as the cost of capital is too high to make the numbers work, each and every day from here.

And each time it happens, more cash is allocated to interest expense than something else or some business doesn't make it. Throw in the ever-growing needs of the U.S. government, which is now crowding out the private sector. This is a process of tighter money and less financing availability that will take years to play out, again assuming the Fed is committed to keeping rates higher for a while.

The longer rates stay high, the greater the economic risk. Every recession since 1969 has been accompanied by an inverted yield curve. The 2/10 yield curve hit peak inversion (a 40+ year high) three months ago. History says there will be a recession 6-9 months after:

Stubborn inflation is occurring for several reasons:

* A Still Vibrant Residential Real Estate Market. Just look at record homebuilders' share prices! The rapidity and magnitude of Fed rate hikes have resulted in the mortgage market proving to be far less rate sensitive than assumed. A feckless and fatuous Federal Reserve, with all of their PhDs in economics, failed to understand the basic thesis that mortgage holders with a 3% mortgage will not "trade up" to a new house if they have to assume a new 7% mortgage. Dumb is an understatement. As a result of monetary policy, and its impact of producing a quick thrust in mortgage rates, the inventory of existing homes for sale is near record lows and home prices have failed to decline coincident with sharp hikes in rates.

* Expansionary Fiscal Policy During Covid. $2 trillion of spending from Washington in three bills: the Infrastructure Investment and Jobs Act, the Creating Helpful Incentives to Produce Semiconductors and Science Act, and the Inflation Reduction Act, and the effects of the pandemic are blunting the impact of higher interest rates. Even after COVID, government spending today is +10% year over year! The projected U.S. deficit will be over $2 trillion in 2023.

Furthermore, large savings inflows – 70 million Americans received an +8% cost-of-living adjustment on their social security income, the biggest boost in 43 years, and a 5% interest rate available in a short-term savings account remain catalysts to continued buoyancy in consumer spending.

* Wage Inflation Is Stabilizing At High Levels. We are still at near full employment:

The impact of relatively high home prices, a resilient consumer, and stubborn wage inflation are contributing to sticky core inflation rate (2x above the Fed's target) which has mandated the Federal Reserve to consider more aggressive interest rate strategy over the second half of this year:

Conclusion

The ultra-low interest rates over the last decade and a half will go down in history as the accumulation of consensual hallucinations of investors, corporate managers, and the Fed.

To date, AI hysteria, a market structure dominated by momentum-based products and strategies, a top-heavy equity market, and strong inflows of liquidity – perversely delivered by a regional bank crisis – have buoyed stocks and have resulted in near record valuations based on history.

Poorly timed monetary policy is now leading to a synchronized series of rate hikes around the world, still stubborn inflation, rates "higher for longer" (an ever-higher risk-free and equity-like return from fixed income), rising corporate and real estate defaults, slowing global economic growth, and a still unfinished fight against inflation. These and other factors discussed in the body of this note could contribute to a hangover in equities in the second half of 2023.

And, then there is Russia and China...

Thank you, Doug!

2) Susan and I had a great first day on our Backroads trip yesterday, doing two 12-mile bike rides before and after lunch through the vineyards and orchards Hood River Valley of northern Oregon, in the shadow of Mt. Hood, behind us in this picture:

I think I'm genetically wired to want to climb every mountain I see... so when I saw Mt. Hood, I called two guiding companies to ask if they had a guide available on short notice.

My plan was to take an Uber 45 minutes from our hotel in Hood River to the trailhead at Timberline Lodge late last night, meet the guide, starting climbing a bit after midnight, summit by sunrise, and get back to the trailhead by mid-morning. Here's a map of the climb:

Alas, my perfect, epic plan was foiled by the calendar – the climbing season on Mt. Hood ended on July 2 because the warm summer weather causes rockfalls as the snow and ice melt. Rats!

Best regards,

Whitney

P.S. I welcome your feedback at WTDfeedback@empirefinancialresearch.com.