For the month of October, the Caravel Capital Fund returned 0.06%.
The month of October was a challenge by most measures. The size and speed of the price changes in bond, currency, and equity markets left us asking, “What pool of capital could be this impetuous? Surely endowments, pensions, sovereign wealth funds, and long-only managers cannot allocate capital confidently amidst these conditions?"
Yet we continue to see this same behavior so far in November. Caravel Capital’s mandate is to identify mispriced securities, implement strategies that exploit these conditions, and do so while mitigating systematic risk. We then determine whether the opportunity offers our partners an acceptable risk-adjusted return. While we avoid deviating from this approach, we like to highlight market changes to help our partners better understand why Caravels returns are independent of stock index returns. We want to illustrate three other strategies that may contribute to current market behavior.
1) FCI Fundamental Conviction Investing
2) BTD Buy the Dip
3) FOMO Fear of Missing Out
Fundamental Conviction Investing has proven its merit over many decades. It is based on the analysis of corporate information and then the distillation of these findings into an investment thesis. This approach can be frustrating as it requires patience in the face of short-term market gyrations. Over the longer term, it produces above-average returns if done correctly. Think Warren Buffet or Prem Watsa.
BTD investing disregards the patience required by the Fundamental crowd. This group tends to wait until assets dip 5–10% before buying, assuming the overarching uptrend will continue. It seems a bit unrefined, but this approach has paid off nicely for the past 20 years. Since 2002, BTD investors have experienced only brief periods of pain (albeit the kind that requires a prescription). The great recession of 2008 saw stock prices drop almost 50%; however, the length of time these investors experienced pain was relatively short. The market topped in April 2008, bottomed in March 2009, and then shot upwards like a SpaceX rocket. So, the pain lasted for less than ten months, top to bottom. In 2020, the time spent in the waiting room was even shorter. Shouldn’t we learn from those experiences and join in?
First, consider how little BTD investors had fun during 2000-02. The S&P 500’s first material drop of 25% came between September of 2000 and April of 2001. Back then, western central banks had not discovered Quantitative Easing (QE). Hence, as the economy slowed, stock prices experienced a second downward leg of the bear market with no monetary stimulus to rescue them. This second leg was due to a recession in corporate earnings. Earnings bear markets are not affected by valuation multiple contractions (the numerator) but rather by decreases in corporate earnings (the denominator). Layoffs tend to alleviate the short-term pain but only exacerbate the related reduction in consumer activity. To avoid this cycle from gaining hold in 2008, central banks adopted a monetary tool invented in Japan in the late ’90s (QE). This tool lowered long-term borrowing costs for individuals and businesses. If you exclude the knock-on effects that Japan is dealing with today, it worked just dandy. The Fed and other central banks have taken this tool off the table to avoid repeating Japan’s mistakes. In fact, they are doing the opposite (Quantitative Tightening/QT) to help relax inflationary pressures. This tells us we are all but assured to experience an earnings bear market in the coming 3-4 quarters as corporate profits begin to suffer from waning personal consumption and higher costs.
Remember that BTD investing has gone so well since the tech bubble burst that most money managers under the age of 45 only know it as a successful strategy. Fundamental investing has underperformed BTD since 1997. The legendary investor Julien Robertson (founder of Tiger Asset Management) quit in 2000 as he felt he could no longer compete. BTD investors don’t care that the next two years of corporate profits will fall or be stagnant, and they buy into high-valuation markets because it has worked for their entire career. We should worry when BTD investors realize the approach is unlikely to pay off until central banks once again initiate QE. We expect they will be waiting quite a while.
The third approach is FOMO investing. While it exploded post-pandemic, this phenomenon has been around for some time. In the wake of the crypto crisis, it has gained a much wider audience. The approach, like BTD investing, does not rely on fundamental analysis. Unlike BTD investing, it does not wait for a 5-10% dip in asset prices to invest.
Instead, this approach relies on media pundits, promotional articles, and water cooler conversations to trigger capital deployment. The FTX collapse has exposed a group of FOMO investors who we won’t likely hear from again in our lifetime (likely because they will have been quietly fired). This cohort is not alone. Canada’s own Justin Bieber spent USD 1.3 million on an NFT. The whole crypto experience looks eerily similar to the Dot Com experience… 90% is garbage, and of the remaining 10%, most are super long shots. Mark Cuban, who made his first billion in the Dot Com bubble selling his internet radio company, admits the buyers (Yahoo) had no idea why they paid $4.6 Billion. In hindsight, we know they were afraid of missing out. FOMO investors might buy an IPO where the founder’s cool ideas appear more than sufficient to compensate for the company’s lack of revenue, barriers to entry, or market strategy. Cathy Wood comes to mind. FOMO investors tend to follow rich, flashy people who talk up their ideas (sometimes while selling them, like Cuban).
We are of the opinion that an earnings bear market is developing and will likely start in the first quarter of 2023. The destructive power of this Earnings Bear will depend on how high BTD and FOMO investors push valuations from now until then. We don’t see the remedy of QE being used as inflationary pressures would likely return to unacceptable levels. A nasty earnings bear will put dip buyers on a morphine drip and probably put this cohort of FOMO investors in the ground. But if history is any indicator, there will be a new breed of FOMO investors once the next bull market matures, and all its newly minted billionaires get in front of a microphone claiming their (insert gimmick here) company is headed to the moon.
Our message here is simple. We may sometimes have differing views on why other investors act the way they do, but we understand what works in the long run and see no reason to change our approach currently. From the start of this year, our belief that earnings for 2022 and 2023 were overly optimistic has proven correct. S&P 500 earnings forecasts one year ago for, 2022 were $232, have since fallen to $220, and will likely come in lower than that by the time 4th quarter reporting is finished in February. For 2023, estimates began at $250 and are currently sitting at $232. These reductions are only now starting to include the effects of a 400% increase in the cost of 10-year money over an 11-month period. All this while we listen to speech after speech from the US Federal Reserve governors yelling, “WE ARE NOT DONE RAISING RATES YET.” This letter isn’t predicting 2000-03 or 1980-82. This is a reminder that irrational and unreliable investment strategies are still pushing equity prices around. These strategies are based on principles that have failed in similar economic environments. We remain unpersuaded to try them out with our capital.
We thank you for your confidence and capital,
Jeff and Glen
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