Week of Aug 29, 2022

Opening Remarks:

On Friday, Aug 26th, S&P 500 dropped by 3.38% in a single session after Chair Powell reconfirmed the Fed’s resolve to fight inflation. Every single stock in S&P 500, except for five, was in the red. When we broadened our scope to Russell 3000, there were 102 stocks in the green, with 52 of them increased by more than 1% and 50 stocked increased between 0 to 1%. Below is the screenshot of the top 20 stocks, with the % change and their respective sector and industry.

I’d like to draw your attention to BBBY (Bed Bath and Beyond), a meme stock that went from $5 to $30 and then back to $10 in one month. On Friday, BBBY gained 5.94%. See #7 in the chart above and remember, this is the day that almost all other stocks dropped in value. This actually indicates that the meme movement is not over yet. In fact, a quick glance over Reddit posts shows no indication of panic among retail investors. There have been some losses, but the main conversation is about how to take advantage of the situation. So, although we had a shock on Friday, it appears that what is playing out now is the contrarian view that we expressed last week (see our post from last week).

Another noteworthy item above is the type of stocks that gained on Friday. Looking at the ‘Industry’ column, we see a hint of technology repeating in different shapes and forms (if we take software and biotechnology as part of technology). This means that many investors still have faith in technology. In fact, this is the right way to go. If anything could help the developed economies, it would be technology (by increasing the productive capacity).

Let’s answer some questions relevant to the recent developments.

Are we facing a recession?

At GGC, we believe that in the absence of an unexpected shock, a soft landing is possible (that is, we can avoid a deep recession). External shocks could be any of the followings: a massive hurricane that will destroy refineries or pipelines, geopolitical tensions, potential expansion of the Ukraine war to neighboring countries, and finally, another pandemic that could impact other parts of the world and cause further shut downs.

How long does it take for the rate tightening to take effect?

Based on historical data, it takes 3 to 18 months for the policy to make an impact. The psychological impact will disseminate fairly quickly given that we’re in the information age. But the pain of losing money will take a little bit longer to be felt.

Are there other matters in play in addition to raising rates?

Yes. The Fed is engaged in quantitative tightening, that is, it will reduce the size of its balance sheet. Treasury securities (issued by US Governemtn) and Mortgage Backed Securities are the two largest items on the Fed’s balance sheet. Basically, the Fed paid cash (by ‘printing money’) for these fixed-income securities. At certain point, these bonds mature so the Fed will return the bond certificate and get its cash back. Once it receives the cash, it will remove it from circulation. The issuing party has to find someone else to buy their securities. Since the Fed is not the guaranteed buyer anymore, and since the Fed has raised the rate, the issuers should sweeten the deal to get the investors to buy their newly issued securities. This process (inclusive of offering higher interest rates) motivates investors to channel cash to these securities that otherwise would be either spent or invested in the stock market, both of which reduce the value of stocks.

How does the pain of monetary policy is felt by regular investors?

Higher interest rates will make it expensive for companies to start new projects. Fewer projects result in lower growth.
Also, as interest rates are rising, some investors would prefer to invest in safe fixed income that pays 5% interest as opposed to stock market. As the liquidity become scarce in the stock markets, those who bought shares in hope of increased value will have difficulty selling it at a reasonably high price. Many institutions that are restricted to take excessive risk will probably start buying bonds more and invest less in private deals.
Finally, the risk-free interest rate impacts the discount rate. One of the main methods to value companies is discounted cash flow, in which we estimate the free cash flow generated from the company’s operations for the next 10 years and discount it back. The higher the discount rate, the lower the valuation.

Is there a risk of miscalculation by the Fed?

Yes. The Fed is looking at inflation and unemployment, both of which are lagging indicators. The forces that impact these two indicator will have a lasting impact beyond the desired level. This means that by the time that the inflation and unemployment get to the desired level and assuming that the Fed stops tightening right at that point in time, the remnants of the forces that had been built up will still push the economy in the same direction (overshoot).
The good news is that the Fed is aware of this, so the hope is that they will navigate through this smoothly.

What is the best investment strategy?

As we indicated last week, in the current environment, finding good companies is the best way to go (as opposed to index, industry, or factor investing). In addition, companies that pay decent dividends are also our favorites. It seems that the teachings of Benjamin Graham are coming back to life.
One method that we’re trying to use is to buy stocks that pay dividends right before the ex-dividend date and sell them after the dividends are paid and the price is recovered, hopefully within a few weeks. Stocks that pay dividends will lose some value as cash is paid out. But most of the time, they either recover soon or the drop is not as much as it should be. Obviously, there is a risk that when we buy the shares, due to unexpected circumstances, the value of the stocks drop significantly. Therefore, we need to find quality stocks and those that we’re willing to keep long-term in case such a drop happened.
Two of our favorite stocks are PBR and RTL. PBR is Brazil’s National Oil company. RTL is a real estate company in the retail sector that has gone through a major acquisition recently and is in good financial condition. We will provide more details about these companies.

What’s the risk of choosing the wrong investment vehicle during this time?

It is quite possible that we will enter a period of time, probably a prolonged one, that the indices (and investment in them) will result in a meager returns. Basically, no one is going to lose a lot of money, but we can’t really make much money either. Below is the S&P500 performance between 1950 and 1990. After a drop on Nov 1968, S&P500 reached a low of 555 in June 1970. Then, in what that appeared to be a rebound, S&P500 went up to 815 by Nov 1972 (note took almost 2 years). If an investor did not sell at this point, S&P500 would go down gradually to below 400 and hover there until reaching 550 again in 1985. So, an investor who didn’t have good timing (as most of us don’t) could end up investing $100 in 1970 and still having only $100 in 1985 after 15 years. Or, investing in 1975 in an apparent rebound and getting stuck for 10 years until 1985.

Source: Macrotrends

Employment and Productivity Data

On Thursday, Sep 1, 2022, the Bureau of Labor Statistics announced the following:
- Jobless claims for the week ended Aug 27, 2022, decreased by 5,000 to 232,000. Lower jobless claims is generally a good indication for the economy. However, the Fed can interpret this as an economy that can withstand higher rate hikes (for example, a 75bps hike in September).
- Nonfarm business sector labor productivity decreased by 4.1% in Q2-2022 compared with Q1-2022. This is the function of an output decrease of 1.4% and hours worked increase of 2.7%. Compared with Q2-2021, productivity decreased by 2.4%.
- Unit-labor costs in the nonfarm business increased 10.2% in Q2-2022, which is the function of a 5.7% increase in hourly compensation and a 4.1% decrease in productivity. Compared with Q2-2021, unit labor costs increased by 9.3% compared with Q1-2022. This is the largest four-quarter increase in this measure since a 10.6% increase in Q1-1982.
In summary, the release above indicates that the labor force has become less productive. Companies need to hire more people to do the same job compared with pre-COVID. This will erode companies’ profit margins which will gradually show itself in the earnings results in the next two quarters.

Strong USD

The US dollar continues to show strength against other currencies. Below is the chart going back multiple decades. Currently, most investors believe that the USD will continue to remain strong during the next two quarters. That being said, the European Central Bank is expected to increase rates, and if this is accompanied by other central banks increasing rates, the upward pressure on USD might ease.
The implications of a strong USD:
- The cost of raw materials that are sourced internationally will become cheaper for US companies. In addition, if managed properly, US companies can use oversees talent at a cheaper rate.
- For the companies that have international sales, all things equal, the USD equivalent will be lower with higher exchange rates. Therefore, when analyzing the financials, the impact of foreign exchange should be considered. It’s better to use metrics that are not impacted by foreign exchange (such as unit sales) or adjust for foreign exchange.

Source: Tradingview