For the month of June, the Caravel CAD fund was up +0.82%, bringing the total net return for 2022 to +2.42%.
In June, the bear market of 2022 continued to plumb new lows as it tried to discover where sufficient demand exists to satisfy continuous supply. We are acutely aware of how painful the past six months have been for investors. However, current valuations coupled with the most recent economic data suggest that the equilibrium value is closer than many pundits think. We are pleased to have provided our partners with some shelter from a broad meltdown in assets such as bonds (-16%), currencies (-18%), and equities (-21%) so far this year. However, we acknowledge with humility that the odds of doing so and then nailing a pivot right on the bottom are slim (if history is any guide). The Colorado Avalanche only won the Stanley Cup because they played each game as their careers depended on the outcome. We respect and admire that approach. Like the Avalanche, we have significant skin in the game. With that, we would like to explore “Finding the Equilibrium.”
Market prices are determined by needs and wants. If you need heat to avoid freezing to death, you will exchange whatever you have for heat. The stuff you have is of no further value to you if you’re dead; thus, it seems a fair exchange to avoid dying. Need is a crucial element in price discovery. Want is something else. Wanting something means there is discretion. Personally, I love Aston Martin automobiles. However, I don’t own an Aston Martin because they cost about $200,000, and I get more enjoyment from leaving that amount of money in this fund. I don’t need that particular car to survive, so I can choose when it’s the right time to buy one or not. Both the need and the want present knock-on effects. I may want to own bitcoin, but I need to pay the rent. In times of stress, I have to sell or forego my wants to satisfy my needs.
Thus far in 2022, G7 Central Bankers have attempted to slow economic activity to dampen an emerging inflationary cycle:
1. The G7 Central Banks (excluding Japan) stopped Quantitative Easing (purchasing longer-term government bonds to artificially suppress interest rates).
2. G7 Central Banks (excluding Japan) allowed their long-term debt to mature and stopped reinvesting the repayment proceeds into more Government bonds (previous letters highlighted the possible risk this creates). This likely explains why the cost of 5 and 10-year money increased 250% and 100% respectively this year.
3. Central Banks have raised short-term borrowing costs from near zero in January to what will likely be 3% or higher by year-end.
So These actions curtail economic consumption, reduce the fundamental value of stocks, and (coupled with knock-on effects) have caused stock and bond markets to fall. These actions also caused currency markets to readjust meaningfully (often referred to as a “flight to safety”).
Markets have adjusted to the changes introduced by the central banks. These adjustments were driven by the investors’ needs and wants. Let’s explore how investors’ needs and wants impact markets using some examples. Consider an extreme situation where the cost of living rises to a point where some market participants are not earning enough to buy 2,000 calories daily. The cause may be higher mortgage or rent payments (reason: central banks), grocery bills, or transportation costs (cause: inflation). All of these cause the above investor to feel hungry every day. Since starving sucks and can lead to malnutrition and ultimately death, the investor NEEDs to make some changes. Some decide to liquidate risky assets like bitcoins or penny stocks. That is an easy way of showing how exogenous economic changes can impact asset prices by changing our needs and wants. A more complex (and likely) example is when that investor needs to save more rather than spend more on wants: they need to pay more for their mortgages rather than enjoy a new car.
We may need to pay more for transportation to work rather than invest more money into a local bank mutual fund. You know, the bank-owned one that always underperforms because they have underpaid and below-average managers. Under this scenario, we start to see how the vast majority of smaller investors that wanted higher returns (and got them 2019-2021) have changing needs. Costs have risen (15+% over the past two years). Now the NEED is to preserve their capital, and they don’t have as much disposable income. From this, money that may have been available to satisfy the desire to consume goods (thereby improving corporate profits) is negatively affected. This also impacts the amount of money available to give to the massive shadow index-based bank-owned mutual funds.
Now let’s look into larger pools of capital. The couple with 7-figure investment accounts have paid off their mortgage, are ten years from retirement, and notice the term investment certificates at their local branch now offer rates 300% more than they were offering seven months ago. They don’t own any fixed income because those investments paid nothing for nine years. They also notice their high-flying stock portfolio that pumped them 20+% or so for the past three years is down 20%. They decide to redeem that mutual fund and buy the fixed income note offered by their bank. They now have changed from wanting more money from equity markets to needing the security provided by 3% bonds. This same conversation happens down their street with the wealthy young couple who have three kids heading to college. Then it happens in the giant corporation’s lunch room as all the employees discuss the company’s pension plan portfolio, which is down 16%. They all opted for the stock-only fund after watching the markets run from 2010-2017. Now they are concerned. They all decide to switch to the fixed income manager. It’s a pension they NEED. Even though the bond manager for the pension is getting massacred, his ad says, “yields 3.94%.” No one WANTS to swing for the fences anymore. More and more investment managers are getting more money in their bond funds and less into their stock funds. Every day the managers of stock funds are forced to sell shares at lower prices.
The managers can’t just hold cash - the big bank mutual fund they work for won’t let them. The bank owners know the managers are low quality (why else would they take the job for ½ the pay of a private investment manager). Sorry, hammering the big trillion-dollar asset managers is just too easy. I digress, back to finding equilibrium. This selling for need causes asset prices to change. We all want this to stop.
The final group is comprised of the private investment managers – sovereign wealth funds and endowments. BIG MONEY. They don’t have to listen to individual investors’ needs and wants, and the bank owners don’t tell them what to do either. They follow the numbers, and they were lightening up all last year. They have lots of discretion because they use solid sets of empirically-crafted assumptions based on the math. So let’s show you their math and help you to see where Caravel Capital believes big money is waiting and identify where the market equilibrium exists.
First, we tackle inflation expectations. They drove the bus here, so let’s try to determine what the final destination is. The past twelve months are behind us (Yoggi Berra could have said that). Over the last 12 months, we saw oil go from $60 to $115, wheat and other grains rise 60%, mortgage rates +100% or more, and raw materials like lumber, nickel, and natural gas up between 20% to 100%. For inflation to remain at 9.1%, the fundamental components of CPI that generated the spike need to rise the same amount again over the next 12 months. We view this as unlikely, and the brightest minds we talk to would agree. The bond market is telling us this, with long bond yields stabilizing in the United States.
We expect North American inflation to exit this year with a 6-7% handle and core inflation (excluding food and energy) in the 4-5% range. We expect things will continue to improve throughout 2023. Central bankers will all have torn rotator cuffs from patting themselves on the back so much. Current inflation is manageable. From here, North American long-term bonds are 10% from their peak rates…maybe we get the odd day at a 3.40% print. We don’t see another Ukraine invasion or similar exogenous event occurring soon (I will discuss this later).. However, this also means we will likely have an inverted yield curve for around six months. Inverted yield curves don’t guarantee a recession; they just make one much more likely. Central Bankers always overshoot in both directions, which unfortunately means they won’t pause until it’s too late, which usually dictates a recession. A mild slowdown induced by The Fed will likely cause corporate earnings to slow or halt their growth trajectory, not drop off a cliff as many have projected.
Historically, if you have:
1)A slow-growing economy but a healthy one with strong employment demand and strong corporate balance sheets (corporations are carrying low-cost, fixed-rate debt issued during years of QE),
2) A 3% 10-year bond and future inflation dropping as we saw in the early ‘90s (borrowing is still below the rate of inflation which is stimulative for the economy),
3) A market P/E multiple of 15 to 16 times for the S&P 500 (in line with historic multiples - with so much money indexed, we think the chances of a further material deterioration of earnings multiples are low, BUT NOT ZERO)
Then, we get a market equilibrium of 3,330 to 3,440 for today. The current level for the SP500 is 3850. So our implied equilibrium point is about 10% below current levels.
Here is where the science of investing ends and the art of investing begins. As long as we believe that inflation will be brought under control and the long-term cost of money will remain at current levels, the less it is likely the market will sell off. Why? Complacency, for starters – the damage is done. The volatility index has not spiked after a 20% fall in broad equities and a 30+% drop in growth equities. Most of the anxious money (and leverage) has left, and what remains doesn’t seem as panicked. In addition, there is a compounding of growth earnings over time. If an asset price is expensive, but we don’t need the money, we wait. Recall my Aston Martin example, same approach but the inverse.
Think what it will be like for those who moved out of equity funds over the past 6 months and loaded up on 3% 10-year bonds. Those people also see the stock market hasn’t dropped like a stone for a while, maybe it dips in October or September to 3500 or 3600, down 5% from here but not a disaster. They start to feel like they need better than 3%. If we know an item isn’t going on sale and we need it, the fear of missing out pushes us to move early. By Q4 of 2022, we believe forecasters will be calling for modest earnings growth, down from their current 20% growth. This places the S&P 500 12-month forward earnings at $220. Earnings, a bit of tempered inflation, and patience smooth out a more severe bear sell-off.
We believe the market equilibrium is roughly 7% below the current S&P500 Index level of 3,850. According to former head trader GMP Securities, Mike Young, “The market likely doesn’t drop below 3580 because it’s right around October; The Fed says they don’t need to hike interest rates past 3.5% as they see inflation trailing off. If that happens, the market runs like Usain Bolt to 4,000.” The next 12-24 months will be a trader’s market due to slower growth and scary currency levels. But that’s for another letter.
Bottom line, we believe we are at most 5-10% from a market equilibrium, occurring in the next 3 or 4 months, barring a significant adverse geopolitical event. As such, we will be looking to deploy our material cash position into bullish strategies as we continue to pursue market-neutral strategies with returns that meet our thresholds.
If you would like to discuss anything we love catching up with our partners any time.
We thank you for your continued confidence and capital,
Jeff and Glen.
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