Generation PMCA commentary for the third quarter ended September 30, 2024, titled "A Grand Illusion?”
It’s not all-time stock market highs that bother us. We’ve often argued that markets should push up to ever-increasing highs along with the steady ascent of corporate profits. However, the level of stock indexes relative to their underlying Fair Market Values (FMV) has surprised us, especially with our expectation of slowing growth and the deleterious impact on earnings from a potential recession. We are particularly concerned that today’s high valuations are obfuscating problems and that such stretched valuations themselves often undo bull markets.
Shattering the Illusion
A record number of investors expect higher stock prices in the next 12 months. Investors also expect above-average returns to continue over the next few years. This is not akin to driving, where most consider themselves above average with no real implications. Investors extrapolate from recent experience leaving themselves overly pessimistic at market bottoms and too optimistic at tops. Currently, market optimism abounds.
That’s not to say that all stocks should now be sold but that investors ought to be more discerning to seek out undervalued, high-quality companies that can better withstand a potential downturn. U.S. stock markets should run out of headroom soon, since prices have risen above FMVs.
Productivity growth is slowing, while poor demographics and rising debt should impede economic growth. With central banks fighting inflation, aggregate monetary supply has been contracting. In aggregate, the U.S., China, Europe, Japan, and the U.K. currently have negative monetary growth—a rather unusual occurrence—despite recent interest rates cuts suggesting easing. This monetary tightening should stifle growth. And the resulting disinflationary effects should allow interest rates to fall further, ultimately providing a shock absorber for markets. Meanwhile, profit margins are at all-time highs, assisted by price increases for goods and services from the inflationary period of the last few years.
While unemployment in the U.S. remains remarkably low at 4.1%, the most recent figures had significant seasonal adjustments as well as a boost from government hiring—perhaps to enhance figures ahead of the election. Despite solid economic growth, a booming stock market, and low unemployment, consumer confidence stinks, which typically foreshadows a rise in unemployment.
U.S. corporate profits have achieved an all-time high portion of Gross Domestic Income. But profit margins are notoriously cyclical and susceptible to margin compression.
The current buoyant period has exhibited a run-up in stock indexes, low volatility, and exuberant sentiment resulting in unsustainably high valuations—a grand illusion.
Economic Mirage
Not only is money supply weakening, its counterpart, velocity, which corresponds to how quickly money moves around the system, is falling. Financial institutions are becoming too timid to lend.
While interest rates have fallen at the short end because central banks have begun to ease off on rates, it’s unusual that longer-term rates have concurrently risen. Likely because central bank tightening has kept them from buying long-term bonds at a time when others, including foreign countries, have been selling bonds.
The yield curve is un-inverting, moving from inverted, where short-term rates are higher than long-term rates, back to a more normal positively sloped curve—the longer the time frame, the higher the yield. Again, this usually occurs because short rates drop, and long rates hold steady. But long rates have been rising. This also occurred on a few other occasions historically (1921, 1969, 1981, and 2007), and in each instance a recession and market decline ensued.
A couple of months ago, 2-year U.S. government bonds yielded over 1.5% less than the central bank’s Fed Fund Rate. Except for 2020, that level of inversion preceded all recessions over the last 60 years by only a few months.
Inflationary expectations have recently ticked up too. We believe inflationary pressures are easing but if expectations are otherwise, it may be a further impediment to near-term monetary easing.
The latest U.S. jobless claims showed the highest level in 3 years. We are wary of a vicious cycle where wage growth slackens, job losses increase, consumer delinquencies rise, all contributing to weakening consumer demand and further unemployment. Prior to layoffs, employers tend to shorten work weeks which has already begun in the U.S. Full-time employment levels are also down year-over-year and have been so since June. Such declines have coincided with every recession in the last 60 years.
U.S. consumer confidence levels dropped to a level a couple of months ago consistent with recessions. Consumers have materially pulled back on restaurant spending. Perhaps that nudged TGI Friday’s into bankruptcy, after almost 60 years in business. Small business uncertainty has spiked to a multi-year high. And over 28% of consumers surveyed by the New York Fed are looking for a job, way up from 19% last year and at the highest level in 10 years.
Debt levels don’t leave much room for government spending to help without adverse repercussions. Debt to GDP in the U.S. is about 130%, clearly stretched. And it continues to grow because the primary annual budget deficit (excluding interest payments) is 6% of GDP, double 2016 levels. It’s the worst amongst developed nations. Remember the PIGS that were on the brink during the European debt crisis just over 10 years ago? At least Portugal and Greece learned and now run surpluses. Spending cuts and tax increases need to be implemented in most countries to address deficits before more drastic steps are required.
On the bright side, the ISM Services level at 56 in October is still clearly in expansion territory. Services represent a significant portion of private sector GDP. And the U.S. economy is expected to grow by 2.5% this quarter. Unemployment in the U.S. remains low and consumer spending high. And while price levels are high, inflation is abating—core U.S. PCE now running at 2.7%.
We expect continued disinflation driven by lower population growth, technological advances, and debt-suppressed growth rates.
Our Economic Composite, TEC™, has predicted recessions in several developed markets over the last couple of years and continues to warn about the U.S. A current downturn in the U.S. has been avoided thus far since the considerable amount of pandemic-related stimulus and the resulting strong consumer buoyed the economy.
Geopolitical issues remain a concern too. Situations relating to Russia and Iran are unnerving. How President-elect Trump will deal with these world issues is uncertain.
Market Apparition
Unusually, T-bills and 10-year government bonds now yield more than the market’s earnings’ yield (earnings/price). Normally, it’s the other way around—there’s a risk premium which would price stocks lower compared to earnings. Also, the S&P 500 dividend yield—only a paltry 1.3% now—is rarely lower.
Previously, when the market was so heavily concentrated, stocks on an equal-weighted basis (meaning stocks generally) subsequently significantly outperformed their corresponding market cap-weighted indexes. Such pronounced cap-weighted outperformance has also preceded or coincided with the last 4 recessions. Even on an equal-weighted basis, stocks are still at relatively high valuations which generally leads to poor multi-year returns. Valuation tools used to project returns are forecasting the S&P 500 to be flat over the next few years. Historically, when stocks were priced as high as they are now, relative to earnings, more than 80% of the time the subsequent 10-year returns were negative.
On a trailing-12-month basis, the top 10 S&P 500 stocks are trading at a price-to-earnings ratio of about 50, way above the average stock valuation. These top 10 stocks represent a record high 37% of the S&P 500.
Even Warren Buffett, whose favourite holding period is forever, just sold half of Berkshire Hathaway’s mammoth Apple position, likely because its share price simply ran up too high. He’s also amassed Berkshire’s greatest cash position ever relative to its assets. Berkshire itself is fairly valued, on sell in our TRAC™ work, and likely to fall to a floor before moving back to its FMV. It’s also telling that the company’s share buybacks have ceased.
There are also several examples of outright speculation. The amount in leveraged long-based ETFs has ballooned to 8 times that in inverse (short) ETFs. Buyers of options abound too, with half the volume being zero-day options—a relatively new product where an option contract expiration is same day—as if options weren’t already used too speculatively. Options were initially designed for hedging purposes, so this is an instance of Wall Street running amok.
It’s not just stocks. Gold and Bitcoin have reached all-time highs. The amount of money in Blackrock’s Bitcoin ETF just surpassed its Gold ETF. Both gold and Bitcoin are in major uptrends which could extend further; however, they already trade too high versus their respective costs of production which normally act as an anchor (with a reasonable premium). And gold, which generally correlates with movements in real interest rates, has detached in the last couple of years, likely because of excess demand both from speculation and central banks—China and Russia have been significant buyers. It should be obvious why we’re currently not investors in gold or gold miners.
Meanwhile, futures dealers (considered the smart money) are a record high 70% net short market index futures.
Self-Deception
Yet U.S. investors’ allocation to stocks is at a record high, likely too high for this fickle group. At the same time, October showed a record monthly decline in allocation to bonds. And mutual funds hold record low cash positions. At other times, when the allocation to stocks was at highs, major market peaks resulted.
Over 40% of Russell 2000 companies are unprofitable, even higher than at the end of the Great Recession.
Company insiders, those who know their businesses best, are selling in droves right now. Last week there were 6 insiders selling for every buyer, the most in the last 10 years. One key exception is oil and gas producers where buyers handily exceed sellers.
Markets don’t necessarily reverse, as individual stocks do, once at FMV because rotations tend to occur with fairly valued stocks becoming cheaper and vice versa; however, few sectors remain undervalued. As such, the markets are susceptible to a coordinated decline, even without a recession.
With stock prices so high, vulnerability to bad news is heightened. Therefore, the market is susceptible to issues such as: further long-term interest rate increases; a pick-up in unemployment; a rise in oil prices (and at the gas pumps); a continued increase in office vacancies, already nearly 20% in the U.S., up from about 11% pre-pandemic, which should cause pressure for lenders; the impact from record low housing affordability, as house prices remain high and mortgage rates stubbornly high as well; and, a further weakening in consumer savings rates, along with the resulting decline in spending on hard goods and services.
Our Strategy
Wary of a recession and since we believe markets are fully valued, we continue to hold a partial hedge against market declines for our Growth accounts by shorting an S&P 500 ETF (or holding an inverse long ETF) and/or the Vanguard Total World Stock ETF.
We continually screen for and analyze companies, searching for quality businesses with competitive advantages, high returns on invested capital, strong free cash flows, and healthy balance sheets, whose share prices are undervalued relative to our FMV estimates.
We are being forced to look at many more companies than usual because most companies today are fairly valued or overvalued. Therefore, we remain defensive for top-down and bottom-up reasons. Still a further market rise, for example of 8-12% to the next S&P 500 TRAC™ ceiling, could be in the cards.
Our Portfolios
The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios—Recent Developments for Key Holdings
All Cap portfolios combine selections from our large cap strategy (Global Insight) with our small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. The smaller cap positions tend to be less liquid holdings which are more volatile; however, we may hold these positions where they are cheaper, trading at relatively greater discounts to our FMV estimates, making their risk/reward profiles favourable.
Orca Energy Group Inc (CVE:ORC.B) announced that the government of Tanzania was preventing Orca from entering new contracts for its ‘additional’ gas, and that it expected the company would continue to sell the same amount of ‘protected’ (at cost) gas, despite the expiration of contracts in August. The company has announced that it intends to sue the government. Further discussions between both parties should take place in December. While this is disappointing, the company has over 50% more cash per share, net of all debt and payables, than the current share price. Several other companies have recently sued the government and have been successful. In the meantime, we believe that the government is likely to be rational and allow the new contracts and even extend the lease of the property beyond October 2026 since it appears to be in all parties’ interest to do so. Regardless, we expect an outsized return from cash on hand, free cash flow over the next couple of years (even at reduced billing), and proceeds from a lawsuit and/or arbitration, if it comes to that and even if it takes some time to collect.
All Cap Portfolios—Changes
Changes to our large cap positions are summarized in the Global Insight section below.
Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. At an average of about 76 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear much cheaper, in aggregate, than the overall market.
Global Insight (Large Cap) Portfolios—Changes
In the last few months, we have made several changes in our large-cap positions. We bought Coterra Energy and Sirius XM Holdings (again). After recently buying both Comcast and Hong Kong Exchanges & Clearing, we sold each of them when both lifted to TRAC™ ceilings in line with our FMV estimates and we sold Capital Power, Quest Diagnostics, and Cooper Companies for the same reasons.
Coterra Energy Inc (NYSE:CTRA), which we’ve also owned before, is a low-cost oil and gas producer operating in the Permian, Marcellus, and Anadarko basins in the U.S. The company prides itself on having the lowest costs and highest cycle times in Susquehanna County and Permian. The company stands to benefit from falling costs—both from materials and operations. While commodity prices could continue to be volatile, and potentially fall in a more severe economic downturn than expected, the company’s low cost should buffer it. Coterra plans to pay out 50% of excess cash flow in the form of dividends (it already yields 3.1%) or share buybacks. Our FMV estimate is $35, which could rise materially if oil prices rise as we anticipate because global oil inventories are historically low and demand remains robust.
Sirius XM Holdings Inc (NASDAQ:SIRI) was recently re-purchased because it fell significantly (last quarter, we bought and sold it when it rose close to our FMV estimate). Once its reverse merger with previous 82% owner Liberty Sirius XM was completed, arbitrageurs and others lost interest. While company growth has slowed and the market is wary of competition, customers remain loyal with annual turnover of a mere 1.6%, and opportunities to grow could be significant, through advertising, marketing new genres, and appealing to a younger audience. Meanwhile, capital spending on new satellites peaks this year and next year’s free cash flow should lift to $1.1 billion and about $1.6 billion in 3 years, even with little top-line growth as capital spending normalizes. The company now has a significant new owner, Berkshire Hathaway, who has recently amassed over 33% of the company. Our FMV estimate is $45. Its dividend yields a meaningful 4.2%.
Income Holdings
U.S. high-yield corporate bonds (ICE BofA Index) yield 7.0%. Unusually, long-term government bond yields have edged higher since the U.S. started to lower short-term rates. While declining inflation should allow rates to fall across the board, the lack of sufficient buyers for longer-term bonds could cause a further rise in longer-term rates. Just like the overzealous sentiment in the stock market, spreads in the U.S. high-yield corporate bond market are the narrowest in the last 30 years (only slightly lower in May 2007). Our continued concern about a pending recession and the tighter credit spreads and rising delinquencies that would accompany a downturn have kept us defensive.
Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 6%, and most of our income holdings—bonds, preferred shares, REITs, and high-yielding common shares—trade below our FMV estimates.
We recently bought Northland Power Inc (TSE:NPI), a renewable power utility with a focus on wind, solar, and natural gas fired power in Canada, the U.S., and Europe, because it yielded 5.6% and traded below our $26 FMV estimate. And we purchased Dream Industrial REIT, whose industrial properties, mostly Canadian and European, should benefit from higher rents as leases renew from its diversified stable tenant base, while the REIT traded at a 5.1% yield and well below our $18 estimated FMV. We sold Capital Power after it rose near our FMV estimate.
Under No Illusion
Our call for an economic downturn has been too early and our resulting defensive posture has caused us to trail the markets’ performance during the recent upward-trending market. But we still see clear risks, and we remain concerned that the markets’ high valuations may be illusory.
We will continue to avoid overly popular, expensive companies and focus on investing in undervalued, high-quality, noncyclical businesses. And hold hedges that ought to protect our portfolios as they benefit when market indexes decline.
What we practice isn’t magic. It’s based on the analysis of company financials and the appropriate price to pay compared to each company’s expected future earnings stream. Not an easy task, but a simple one for us to articulate and stick with, and one made easier when we focus on high-quality, more predictable, companies. Investors constantly create opportunities for us by temporarily shunning certain individual companies, leading to bargains for us to purchase.
Only time will tell whether today’s lofty index valuation levels represent a grand illusion relative to prevailing and forthcoming economic underpinnings. Either way, our macro and micro analysis suggest that investors are simply too optimistic about stocks generally, boosting overall risks. Market declines may be closer than they appear.
Randall Abramson, CFA
Generation PMCA Corp.
November 20, 2024
