Clients of the Firm, 

The S&P 500 closed yesterday at 3,822 down -19.80% YTD.  The Bloomberg Long Term Corporate Bond Index is down -23.90% YTD, no better. Since 1965, only three other years were worse performers for the S&P 500 these were 1974, 2002 and 2008.   That said, the S&P 500 has moved about 10% higher than lows set earlier this year at 3,491. While this is encouraging, we still see potential valuation challenges as earnings in 2023 will likely be impacted by changing economic conditions.  In short, the multiple compression phase of the market correction appears to be waning, but the earnings recession may be about to begin.  The extent to which earnings materialize in 2023 will have much to do with market performance in what may turn out to be a surprisingly good year if history and the market’s forward pricing mechanism have anything to do with it.   

The yield curve remains steeply inverted, meaning longer dated bonds are yielding less than the shorter dated counterparts.  This inversion is due in large part to market expectations that the Fed will be successful in slowing down the economy, creating higher unemployment and at least a mild recession.  Inverted curves portend recessions, the Federal Reserve Bank of Chicago issued an interesting letter on the topic in 2018.  You can read that economic piece here:  

https://www.chicagofed.org/publications/chicago-fed-letter/2018/404   

Inflation, while slowing down, has persisted.  Recent stock and bond rallies have been attributed to the moderation of inflation in the two most recent CPI reports.  You can find those reports here: 

https://www.bls.gov/news.release/cpi.nr0.htm 

That said, inflation for November 2022 was still +7.1% y/y which was over three times higher than the Fed’s target of 2%.  

In the real economy, we are continuing to observe dramatic slowdowns in digital ad spending from our private channel checks.  Not surprisingly, we are seeing public announcements of large layoffs from major players in the space and layoffs downstream of these players.  

Retail inventory continues to be an issue, with retailers overbuying supply and now forced to heavily discount to alleviate inventory stocks and clear their distribution channels.  We expect robust discount shopping to occur over the holiday period and into the post-holiday period.   

Energy prices are inflated, particularly in Europe, due to supply constraints from the Russian war with Ukraine.  Recent OPEC announcements and vacillation on supply levels continue to impact oil prices, while Q1 2023 natural gas prices have come way down from the Aug 26, 2022 peak.   

The dollar has weakened significantly against the JPY, GBP and EUR over the past several weeks.  This is most notable in Japan which abruptly changed monetary course this week.  In addition, the UK experienced GILT yield jump conditions after the resignation of PM Liz Truss and the appointment of Rishi Sunak and the GBP/USD cross has materially strengthened since.   

Finally, significant alleged fraud was revealed in the FTX bankruptcy causing some to question the future of crypto.  Confidence in the asset class has been shaken to its core and major financial players are stepping in as custodians of crypto to take advantage and fill the confidence void. The damaged credibility will take substantial time in our view to regain investor confidence.  

Q3 corporate earnings reflected this environment with strength in energy, weakness in some retailers and significant weakness in digital advertising and crypto.  Travel continued to outperform and industrials beat weakened expectations.  Large tech companies disappointed expectations, but remained solidly profitable albeit on lower than expected growth trajectory.  

Where does this leave us from an investment positioning perspective?  A better way to think about this might be: what is the differential in return likely to be from risk assets versus risk free assets at +3.67% for the next year or two?  As one invests, comparing estimated returns to the risk-free rate is a commonsense measure to undertake.  The earnings yield for our forecast of S&P 500 earnings for 2023 is currently 5.79%. This figure is a 2.12% premium to a 10-year Treasury bond.  Significantly higher premiums have existed in the recent past when rates were suppressed.  Interest rate compression made equity investing an attractive alternative to the return of a risk-free bond.   

Recent multiple compression in equities reflects this lower equity yield premium and, thus, we are seeing more rational pricing in equities given an assumption of terminal Fed Funds around 5%.  Should rates continue to increase substantially above these levels, we would likely see additional multiple compression into a higher terminal rate reflected in stock prices.   

Investors might observe that good news is being sold by the market.  This seems contrary to what we have come to expect in recent history.  The reason for this dynamic is that a faster growing economy and continued good employment numbers increase the likelihood that inflation will persist.  This expectation implies that the Fed’s terminal rate will be higher than today’s levels.  Thus, multiples compress further to reflect this expectation. 

Balancing portfolios should be undertaken looking at these opportunity costs.  For example, in today’s environment a short-term Treasury bond yields north of 4%.  These are held either directly or through institutional money market funds which allows an investor to participate in these yield levels with very little price risk.  By contrast, a stock with a P/E of 20 has an earnings yield of 5%.  This implies that the initial rate of return of the equity investment is only 1% higher than the bond.   

Longer-term equities tend to outperform because management teams have tools such as cost cutting, product innovation, share buybacks and price inflation to increase profits over time.  Therefore, the equity earnings yield of a good company increases over time. 

Next year is likely to be a year in which management teams try to leverage these tools to first stabilize costs and then try to grow earnings despite economic headwinds.  We expect the economic pressures and increased cost of capital will accelerate cost cuts and downsizing of structural costs.  While these actions may initially bring down stated EPS, they eventually result in leaner operations that are more profitable when the economy resumes a growth trajectory.  

The market is a forward pricing mechanism that begins to price in the higher earnings capacity of companies long before it occurs.  Examples of this phenomenon were the COVID 2020 March lows which occurred well before the reopening and the March 2009 lows which happened significantly before the actual economy began to improve. While these market lows were at substantially lower valuation levels, they are instructive regarding market turning points and their forward-looking nature.  Indeed, the 10 Year Treasury yields in 2022 peaked before the Fed stopped raising rates and are anticipating lower rates 10 years out when compared to today’s Fed Funds. 

Projecting when the market will bottom or when it will begin to forward price improvement is generally a fool’s errand.  Estimating when the market is cheap enough to begin adding or dollar-cost averaging is a better endeavor.  The latter task is enabled by estimated forward earnings and the multiples for those earnings and applying a margin of safety to the price we pay.  This is not an easy task, especially in an uncertain economic environment.  That said, using this framework generally reduces downside risk and allows for rational decision making albeit around a set of assumptions that are based on earnings analysis.     

While the market conditions have changed (as they always do), our approach to investment analysis has not.  Rational buying or selling based upon a set of risk assumptions and opportunity cost assessments remains our approach.  Even as we tramp the difficult path of a bear market, it is important to remain grounded in a disciplined approach to what one pays for investments.     

As we peer into 2023, our expectation is for the market to reprice based on expectations for the forward path of earnings and interest rates.  A shallow recession is our base case scenario that will be coincident with aggressive cost cutting, share buybacks and low-cost acquisitions that are accretive to earnings over the longer run.  The market will assess what the earnings boost will be from these measures.  Our view is that this assessment combined with a Fed pause in rate hikes will be a catalyst for equities into the back half of 2023.  In the interim, we expect volatility will remain creating opportunities for enterprising investors.  Those opportunities remind us of the oft quoted Warren Buffett line, “The most important quality for an investor is temperament not intellect.” 

On a closing note, we want to thank all of our clients for the trust they have place in us this year and every year.  Volatile markets are challenging to weather and we appreciate the continued confidence in our management of your funds.   

Sincerely,

Peter C. Wernau

President, CEO
Wernau Asset Management

http://www.wernauassetmanagement.com/
 
Office: 617.871.0029 
Fax: 617.507.8155
 

Wernau Asset Management

30 Western Ave Suite 206

Gloucester, MA 01930

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