The era of reliably persistent trends is likely over

The era of reliably persistent trends is likely over

30 November 2022 from Mikael Syding

Protests intensify in China. It is reminiscent of the Arab Spring. The people have had enough, this time of loneliness due to covetous restrictions. In North Africa, the revolutions were due to hunger, but being locked up and strictly monitored by contagion monitors may be even stronger motivators than hunger. However, Xi is more likely to hit back hard than relinquish his newly tightened grip on power. As with many other variables in the 2020s, I expect many tosses back and forth between hope and despair. Besides, should Western investors really hope that China eases its Covid policy, or could it actually cause more problems than it solves? At least short positions in Tesla, Apple and AMD are better off with a shutdown China. On the other hand, oil companies Occidental and ConocoPhillips would likely benefit from higher oil prices as China's economy picks up.

Right now, there are a number of warning signs that point clearly to recession. Oil prices have fallen and the price curve is showing contango despite record low oil inventories. Furthermore, China has lowered its bank reserve requirement ratio, which in the past has meant that China is trying to counteract negative externalities from international capital markets. And if that wasn't enough, many key yield curves are inverted. In the shadow of these problems, investors are understandably hoping that China will make a covidpivot and open up the economy. The stimulus and increased internal social stability is welcome, even if it leads to renewed bottlenecks and some more inflationary pressures. Still, the stock market already seems to be discounting a central bank pivot after a single slightly better inflation figure in the US, so the price increase threat is considered old news for now.

The focus has thus returned to the strategies that worked in 2008-2021, i.e. high risk and high growth almost regardless of the valuation multiples paid. China, however, seems in no hurry to open up. It is unclear why, but the country lacks effective vaccines, and the elderly population is generally poorly protected. A contagion wave would force new shutdowns but also lower the credibility of the party leadership and increasing impatience and protests among the people. Xi Jinping can't afford that. There are some faint hopes that China will enlist the help of better vaccines from the West to untie the Gordian knot, but that would also be to lose face.

The Fed may have signalled some caution in the latest meeting notes, but the market has already discounted that and more during this fall's stock market rally. You don't go back to the old era that easily, especially in the face of a period of inflation and deglobalisation. Fourteen years, 2008-2022, of 14% annual returns for the OMX total return suggests a cycle of at least 5-6 years of zero returns, perhaps double that time if you listen to John Hussman. Higher oil prices and interest rates are likely to drag down both profits and valuations for a long time to come for almost everything except oil companies and banks. Just today (28 November) Lagarde told the ECB that she doesn't think inflation has peaked yet, and that the ECB will raise interest rates in 2023 even if the economy weakens. Central bankers are serious about inflation being priority one. On Wednesday (30 November) we will see if inflation remains above 10% in the EMU as expected.

The era of reliably sustained trends is likely over. China's coalition policy, Western inflation and monetary policy, OPEC and Russia's oil policy, borrowing-driven consumption - all represent examples of variables that are likely to remain volatile until the economy and stock markets find a longer-term balance. In addition, volatility itself can create uncertainty that reduces investment appetite. Perhaps it will cause the stock market not only to fall to a normal level but even to become cheap for a while. Procyclicality in the supply and demand for credit tends to have that effect periodically - just as it causes overvaluations in good times. Right now, stocks are still very expensive by historical standards. In fact, the OMX index has only fallen 6% in the last twelve months so there is hardly a correction to speak of, just a small adjustment to the last extreme uptrend phase.

Here's a little perspective on valuation and returns. Over long periods, earnings multiple of about 15, or sales multiple of 1.5, or market capitalization/GDP of 1.0 has been shown to yield about 10% annual returns over the subsequent one to two decades. That has been the average, plain and simple. Higher multiples have produced lower returns and lower ones have produced higher returns. Where subsequent returns have deviated from the norm in one period, this has been corrected in the following period. Thus, better than expected returns have been followed by worse. The best forecast value has been for a period of ten to twelve years, as the manager John Hussman often reports on his website.

The S&P 500 set a historic valuation record before the pandemic. At that time, the stock market was valued at almost 3.5 times the historical average. Now, one of the most reliable valuation measures is 2.5 times the average, which means there is still a 60% downside - without making the valuation more than perfectly normal, i.e. not even "cheap". Typically, today's valuation and economic conditions mean that the S&P500 can be expected to deliver zero total return over the next ten to twelve years, for example in the form of two separate downturns with an upswing phase in between.

This is hardly an environment suitable for "buy and hold" strategies or taking big risks on expensive hopefuls where the cash flow to justify the market value is far in the future. No, the fact is that you have to engage to some extent in market timing or at least sector or asset class timing. By daring to be a little contrarian, you can continue to have exposure to selected parts of the business value chain, or park your money in inflation-linked fixed income and precious metals. But you probably have to forget the zero-interest-rate era's motto that equities are the only thing that matters and that any time in the market is good time. No, it is rather that hard work and qualitative thought pays off again in what is otherwise considered the world's most competitive activity. The strange thing is that for so long it could be a generally accepted truth that one would rather not do any intellectual work at all regarding the overall situation or company valuation.

In the book "The Richest Man in Babylon" (NOTE! definitely not a book recommendation) it is recommended to always save consistently and to wait with luxury consumption until you own your home and a fortune. You should also hurry slowly and let interest on interest do the work, and avoid high risk driven by greed. At the same time, you are encouraged to work hard and thus be ready to seize good opportunities when they arise. Some of the ideas are a bit paradoxical, but by and large it's about not hoping for luck and quick wins. Opportunities do always arise from time to time, if you are a well-deserved good social network, but to seize opportunities you also need to have knowledge and capital ready. After all, without dry powder there will be no explosions. One of the concluding chapters highlights the importance of timing. When an opportunity arises, you have to have the sense to understand it, the psychology to seize it and the resources to do so. I read it as buying stocks when they are cheap and others are on their knees due to high debt yields, buying gold in anticipation of the next period of inflation while others greedily throw themselves at the same expensive haymakers as the rest of the crowd, and more specifically buying the economy's framework in the form of oil and banking when those sectors swing back in share of the stock market to the detriment of fluffier sectors without significant near-term cash flow relative to company value.

So is now not the time to look for a hidden super yield somewhere? Forget ten-baggers and 100-baggers unless you have a lot of specific knowledge and a network that gives you reasonable opportunities to get in early and cheap. Your life-changing investment today is not about hoping that irrational speculative bubbles and multiple expansion will do all the work for you by lifting old winners back to the top. That's exactly the greed and hope for luck that Babylon warns against.

More rational than hoping for an imminent solution to China's covid crisis, the West's inflation problems and the energy crisis is to build resilience to a continuation of the troublesome trends. That means focusing today on cheap sectors with clear cash flows. Here, oil companies and banks are in a good position with earnings multiples of 9-10 and also positive correlation with rising inflation, widening interest rate spreads, higher oil prices and, not least, cannibalisation of other stock market sectors in the form of both earnings and multiple-enhancing sector rotations. Fixed income and precious metals such as gold and silver (or mining companies) are also attractive alternatives to expensive technology, engineering and consumer staples companies. The strategy then is to wait for more normalized overall stock market valuation levels and gradually shift from the parking lots to more exciting companies as the panic intensifies. However, it's important not to get too greedy in the hunt for bargain prices either and start accumulating in time.

For now, it's gold, oil, banks and interest rates. They are not tenfolds, but they can at least be considered a bit cheap and represent excellent investments and "dry powder" relative to the other options. At the next stage, after all, some hopefuls in sustainable energy and green transition may deserve a bet. I'll have reason to come back to uranium, nuclear, energy storage and battery minerals later, perhaps as early as the summer of 2023. Your life-changing investment is not in taking wild chances at every turn, least of all now. It lies in learning about valuation and wise reflection, and about time in the right market at the right time, rather than mindless time in the almost meaningless concept of "the stock market".


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03/02/2023 12:04:19


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