Q3 2022
Kinsman Oak Investor Letter Q3 2022
October 25, 2022
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MARKET COMMENTARY
The S&P 500 total return is -23.9% year-to-date. During the first nine months of the year, we have experienced four rallies of 9% or greater, only to make fresh new lows each time. The largest of these rallies occurred between mid-June and mid-August where stocks bounced 19% from the bottom and then proceeded to give it all back and more by the end of September. Bear markets have historically had numerous intermittent rallies – often sharp and prolonged ones – before a sustainable bottom forms.
Factors typically associated with bull markets – declining interest rates, increasing liquidity, disinflation, economic growth, geopolitical stability, etc. – are all reversing quickly. Valuation multiples have experienced a historic collapse. The S&P 500 currently trades at ~15x normalized forward EPS estimates, down from ~23x last year. The caveat, of course, is one would have to believe the forward estimates are accurate. Either way, smoothing the analysis using a five-year mean reverting average paints the same picture – a massive valuation crunch.
As of the end of the quarter, the S&P 500 and Nasdaq 100 were both trading at two-year lows. Even worse, the Russell 2000 has given back all gains since June 2018. These are sobering statistics given the unbridled optimism two years ago. Long gone are the days of meme stock gamma squeezes and ‘money printer go brr’ jokes. TSLA is the obvious exception but pretty much every other post-Covid highflier has been decimated from their all-time highs. For example, former market darlings such as PTON and CVNA are both down -96% from their peak (not a typo).
What has been particularly challenging thus far is there has been nowhere to hide. Certain sectors have performed better than others, relatively speaking, but only energy remains unscathed. U.S. Treasuries, the ultimate risk-off asset, are down anywhere from -19.5% to -36.5% year-to-date depending on the maturity. According to Bank of America, the 60/40 portfolio is annualizing its worst year-to-date return in the past 100 years (Appendix A).
While overly aggressive dip-buying has been a rewarding strategy prior to this year, such behaviour has now proven to be detrimental and gut-wrenching for investors. Rallies have continuously experienced lower highs and corrections have experienced lower lows. The S&P 500 three-month realized correlation is at its highest level since July 2020, meaning individual stocks are essentially moving in tandem with the broader market (Appendix B).
We wonder if the current bear market is correcting speculative excesses from the post-Covid boondoggle or if it’s correcting something deeper such as all the malinvestment from the post-GFC ZIRP era. The former suggests the worst of the sell-off is likely behind us and the latter suggests more pain is eventually coming. Either way, where markets go over the next six to twelve months largely depends on how much inflation is truly sticky (LSD vs. MSD) and how big of an impact this recession will have on corporate earnings.
FAR FROM A PIVOT
In our view, the much-anticipated Fed pivot is not imminent. The real policy mistake was keeping interest rates at zero percent throughout 2021 despite increasing inflation, speculative manias in all kinds of risk assets, low unemployment, and enormous fiscal spending. The Fed chose not to proactively raise rates and, in doing so, painted themselves into a corner where inflation is dictating the pace at which they do so now.
An initial underreaction is being met with a subsequent overreaction and this is creating all kinds of carnage in the process. The current rate hike cycle is the fastest it has even been, starting from the lowest point in history, and while the degree of financial leverage is at its peak. We wouldn’t be surprised if something breaks eventually.
As a side note, unlike some investors, we remain unconvinced any Fed pivot will be sufficient reason to recklessly pile back into stocks. In the GFC the Fed started easing in July 2007 and it took almost two years for the stock market to bottom in March 2009. In the Dot-com bubble the Fed started easing in December 2000 and it took almost two years for the stock market to bottom in October 2002. A Fed pivot may coincide with a market bottom this time, but our belief is that relying on one variable as such a signal is insufficient.
CPI is currently 8.2% while the Fed Funds rate is at 3.25%. Oddly enough, we haven’t heard the term TINA used lately even though real interest rates remain deeply negative. It’s almost as if the acronym is merely a figment of overvalued bull markets and serves as a plausible justification to own stocks at any price, but we digress.
Historically speaking, the Fed has only pivoted twice when core CPI exceeded the Fed Funds rate – and both times were almost fifty years ago. This suggests the Fed is nowhere even remotely close to a pivot. FOMC members agree with our assessment. According to the dot plot, members anticipate another 100-bps hike by the end of the calendar year (consensus at 4.25%), and 12/19 members expect the Fed Funds rate to be roughly 4.75% by the end of 2023 which implies another 50-bps hike next year as well (Appendix C).
All of this is a long-winded way of saying the Fed expects higher rates for longer. This leads us to believe the next bull market will be profoundly different than the ZIRP-fuelled post-GFC paradigm. One caveat to our base case would be a scenario where the structural stability of the financial system is credibly threatened, meaning issues much greater than inflation, or political reasons. We believe the Fed would pivot and deal with the fallout later.
PARADIGM SHIFTS
Our base case is the cost of capital will remain above zero for the foreseeable future. Under such a scenario, the next bull market would occur in a non-ZIRP environment, which is significant enough on its own to drive a paradigm shift. On top of that, there is a decent chance the 30-year government bond bull market may have already ended, suggesting the future may look a lot different than the past (Appendix D).
Our belief is the underlying drivers of stock performance from the post-GFC decade will be meaningfully different than whatever comes next. After all, the zeitgeist of yesterday rarely resembles the zeitgeist of tomorrow. Specifically, we believe two of the most significant differences between these paradigms are as follows: 1) Unit economics will take precedent over top-line growth and 2) Margin sustainability will drive valuation premiums rather than storytelling. In short, profit margins and free cash flow will be more important than hypergrowth and TAM.
Unit Economics vs. Top-Line Growth
A non-zero cost of capital serves as a metaphorical offramp from the land of excess into the world of positive unit economics. Interest rates don’t even need to be high for this to hold true. Anything above the zero-bound ascribes an actual time value to money and will suffice. Even a marginal time value will limit the willingness of capital allocators to fund unlimited losses.
An era of free money rewarded companies for pursuing land-grab strategies by selling dollars for fifty cents. Irrational competitors sprung up all over the place with the promise of pseudo-monopolistic market potential once they hit critical mass. Investor presentations often included exaggerated TAMs and profitability projections multiple years out. Funding losses can be justified when there is no time value to money, but that appears to be changing.
Even worse, many of these businesses had structurally uneconomical business models, low switching costs, and fickle customers. Losing money on every transaction cannot be rectified by increasing sales volume. Companies that fall into this category cannot grow their way out of their existing cost structures. Instead, they are raising prices for end consumers while rightsizing expenses. Bloated employee-related expenses are low hanging fruit.
We anticipate corporate expenditures will have to be justifiable from a unit economic standpoint if the cost of capital remains above zero. Hypergrowth under these conditions will be challenging. During the free money paradigm, investors were overly focused on the output – sales growth, subscriber count, DAUs, etc. We believe investors will become increasingly focused on the input – the capital required – relative to the output generated. Companies that can grow efficiently and effectively, utilizing every dollar put into the business wisely, will be rewarded with premium multiples and higher stock prices.
Margin Sustainability vs. TAM
We believe the allure of infinite TAMs will take a backseat to margin sustainability. Structurally unprofitable companies have already been decimated. Founder CEOs that have never generated positive free cash flow are beginning to lose the faith of investors. Cutting costs while maintaining modest growth requires a different skillset than growing revenue as fast as possible with unlimited amounts of funding.
Corporate costs structures will feel the effects of sticky inflation for several quarters (or years) even after inflation begins to decelerate. Increased labour costs, supply chain friction, de-globalization, etc. don’t reverse overnight. Investors will place a premium on businesses that can preserve margins amid numerous headwinds.
On aggregate, S&P 500 companies have posted record high profit margins since the pandemic, in large part due to an unprecedented combination of trillions in quantitative easing and fiscal stimulus. Profit margins peaked at 13.1% in Q4 2021 and are currently 11.6% versus a 10-year average of 9.5% and an all-time average of 7.1% (Appendix E). Clearly, margins have only begun to recede, and we believe they will re-normalize around 9.5%. It doesn’t sound like a significant difference but, all else equal, it would imply an -18% decline in earnings estimates.
RE-VISITING BAK’S SANDPILE
We have written about Bak’s Sandpile in the past, highlighting how stability fosters instability. With respect to financial markets, artificially ultra-low interest rates can result in stable disequilibriums for long bouts of time before problems inevitably surface. Fault lines remain dormant and lull investors into a false sense of security. Participants, overly reliant on historical correlations and probabilities, behave in a way creates enormous tail risks.
U.K. Pension Funds
We have argued price controls in an economy can never work in the long run. Controlling the most important price in any given economy – the price of money itself – is no exception. U.K. pension funds are experiencing the unintended consequences firsthand. In short, ultra-low interest rates created a perverse incentive structure for pension fund managers and the manifestation was an unstable sandpile.
Without getting into the weeds, we can summarize the situation as follows: Pension funds typically have a ~7% return objective. Any return below that objective means the fund is more underfunded than it was in the previous year, which is not great. Over the past decade, it has become more difficult for pension funds to reach their return objective in a world where government bonds yield LSD. The “solution” is venturing further out the risk curve.
Utilizing leverage and swap contracts to juice these LSD yields worked in an environment of falling rates, so pension funds kept doing it. Market participants collectively behaving in this way is a textbook example of Bak’s self-organized criticality. The U.K. pension fund system found itself in a critical state, meaning any incremental change to the system, no matter how small, can ignite a chain reaction that causes significant change.
Enter Liz Truss. She was the proverbial match that ignited the gasoline-doused pension funds. Her proposal to implement unfunded tax cuts and increase government spending simultaneously, at a time when inflation was already double digits, was enough to send yields soaring and cause solvency risk for pension funds absent central bank intervention. Increasing yields put downward pressure on U.K. government bonds, which created more selling pressure, putting more upward pressure on yields, which created more selling pressure, and the process continues.
The underlying issue wasn’t the most recent spike in yields per se. The root cause of the problem was that U.K. pension funds spent years utilizing aggressive liability-driven investment strategies, with increasing amounts of leverage (in a way their risk models deemed safe) and became increasingly fragile as more time passed. Risk models were overly reliant on historical correlations and probabilities, such as the relationships between interest rates, inflation, and present value of future obligations, which proved worthless precisely when needed most.
The Bank of England was forced into emergency action and effectively bailed out pension funds that were receiving margin calls. This is merely the most recent example of how volatility cannot be suppressed forever. Central bankers cannot destroy volatility, and the more they try, the more prone financial markets will be to bouts of sporadic dysfunction. We wonder if there are similar vulnerable pockets of instability lurking in the shadows here.
Where We See Opportunity
We continue to see pockets of opportunity on both the long and short side. High quality businesses with strong pricing power, captive customers, and clean balance sheets will be long-term beneficiaries of this volatile environment. These companies are typically market leaders with large market capitalizations. Another area of opportunity, in our view, are SMID-cap stocks. As a group, most of these stocks have been in a bear market for almost two years and have undergone tremendous selling pressure.
Switching gears, we believe there are plenty of good short opportunities out there too. Specifically, quite a few uneconomical cash-burning business still have up to multi-billion-dollar equity values. Even worse, some of these companies saddled their capital structure with debt to juice low-or-negative-ROIC growth. The bond market is ascribing a real possibility the equity gets completely wiped out as yields range from high-teens to mid-thirties. The challenging aspect of shorting anything to zero is twofold. First, timing entries is challenging as often these stocks experience very sharp rallies. Second, some businesses may be takeover candidates if the value gets low enough.
LOOKING AHEAD
Typically, the one-two punch for most bear markets is a valuation crunch in conjunction with a lowered growth outlook. Right now, valuation multiples remain tethered to real interest rates (thus far the sell-off has predominantly been a multiple contraction as 10-year yields went from 1.5% to 4.2%). We believe if the recessionary outlook continues to worsen, valuation multiples are likely to be driven by expected growth rates going forward.
While we are admittedly bearish, we recognize our bearishness has become a consensus view amongst market participants. Investor sentiment is extremely negative right now. For example, Citi Research’s Levkovich Index is registering post-pandemic lows and categorizes current sentiment in panic territory (Appendix F). Since the creation of the index in 1991, the latest reading of -0.22 appears to be associated with positive S&P 500 forward twelve month returns in every single instance.
Other bullish counterpoints include the strength of the U.S. labour market, inflation is likely close to peaking, and valuation multiples have come back in line with historic norms, further suggesting the worst may be behind us. When we look out longer term, we still believe higher interest rates are untenable with the amount of federal debt outstanding and enormous budget deficits. The consequences of this incompatibility do not appear imminent, but we will continue to monitor opportunities and risks across many time horizons.
Sincerely,
