I’ve just updated my Keeping Score page for November 2022. Results would have been considerably different were it not for the last afternoon of trading Wednesday the 30th–when a strong market upsurge pulled the major indices out of the red and into the black for the month.

After peaking almost exactly a year ago at 4800+, the S&P 500 fell, in the jagged way stocks usually do, to 3500- in the middle of October, before rebounding to the current 3900+.

Where to from here?

Morgan Stanley Chief Investment Officer, Mike Wilson, someone I don’t know, but who has been the most right about the current bear market among strategists who make their predictions public, has been very upfront about his view that the market has one more downdraft left in it. That, he thinks, will come in 1Q23, as companies will stop hoping against hope and announce a final downward revision of their near-term earnings prospects, acknowledging at last a grimmer economic reality than they have so far been willing to admit. This action, he thinks, will drive stocks down to new S&P lows of 3000-3300, establishing a floor from which the market will recover as earnings improve.

There are considerable reasons, that I might classify as market symmetry, for thinking this may happen. This would return, full circle, the market to its position just before the pandemic broke out. It would extend the bear market to at least average length of 12 – 18 months. The market would have lost about 1/3 of its value from the peak (technical analysts love thirds and quarters). And the final dip would more or less coincide with peak inflation and the end of aggressive Fed interest rate hikes.

I also think its correct that publicly traded companies probably still have ugly secrets–like inventories accumulated in too-high quantities and at too-high prices as they struggled with pandemic-induced supply chain shortages. Target (TGT, a stock I own, and which I think is a well-managed company), for example, announced at mid-year that it had lots and lots too many TVs and home appliances, because it had been betting pandemic-induced spending would last longer than it has. After the September quarter it confessed that light-fingered “guests” had made off with the better part of a half billion dollars more than expected of unpaid-for goods. Can we rule out a big inventory writedown after the holiday selling season? NO! Maybe a reason to buy, though.

It’s also right, in my experience, that while in bull markets investors buy expectations of future earnings glory, in bear markets we focus very sharply on the ugly present–and discount it (by selling) in masochistic fashion, over and over again. In addition, I think the focus of trading bots is still mostly (entirely?) on speedy reaction to public announcements, not on forming expectations about future corporate statements, trading those in advance, and then also trading on the difference between those expectation and announcements, once made. In other words: bots are still pretty dumb–although I think this is slowly changing; and even though we might expect 4Q22 results will be ugly, bots will beat stocks up as if no one suspected.

Having written all this, it’s still true that trying to time the bumps in the market road (admittedly, this could be an epic pothole) is probably the least important thing for us as investors to do.

For us, it’s much more important to work out which sectors of the market we want to emphasize and which we want to avoid.

Are there concepts or themes we want to play? For example, I think we’ve barely begun to work out the implications of Washington’s decision to deny the most advanced semiconductor technology to China. I also think the electric car industry, ex TSLA, is interesting, which implies, looking at bombed-out, stomach-churning legacy automakers that have brand names. I suspect that the market isn’t completely finished with the opposition between stay-at-home stocks and back-to-work–meaning selling the former and buying the latter.

As I’ve been writing for a while, I find myself suddenly interested in value stocks–ones where the asset value, including intangibles, far exceeds the stock price. At some point, stay-at-homes will be in this category, but not right now.

Back to a possible 1Q swoon. Maybe it will happen, maybe not. If it does, though, that would be a good chance to upgrade our portfolios–sort of like an end-of-season sale. It’s worth giving some thought to what we might buy–stocks we’d like to own but which seem to richly priced right now.

in general

Inflation is a general rise in prices. ..not just one or two items, because the price of just about anything rises and falls according to regular (meaning, for example, with the seasons or the business cycle) rhythms, but prices overall.

What makes inflation bad is that it messes with long-term planning, like companies building factories or individuals saving for retirement.

Steady inflation at a low level (like 2% or 3% annual price increases) is, in the consensus economic view, the best possible situation. Price stability is a practical impossibility without potential disastrous wage and price controls, as the 1970s taught us, and deflation (falling prices) is the worst, as the Great Depression of the 1930s showed.

I wrote a post a few months ago in which I tried to show that the current situation is nowhere near as bad as it was during the 1970s.

right now

Inflation is now running at a bit above a 7% annual rate. Economists seem to think that about half of this is the result of higher wages and the increased cost of raw materials. The other half can be broken out, I think, into two parts:

–retailers having unusually high-cost inventory. This is the result of the “I’ll pay anything” mentality of getting raw materials or finished goods during the peak shortage period just to have something on the shelves to sell or of incorrectly thinking that the shortage period would go on longer than it has, and

–price gouging. For example, my wife and I are in California visiting relatives. Both back home and here, Chobani yogurt is $.85 a cup in Costco. That’s up from $.75 a year ago. In supermarkets back home, a cup is maybe $1.25–$1.00 if the expiration date is getting close. At the Ralph’s across the street, it’s $1.60. At a Japanese supermarket I went to with my son-in-law, it was $1.99. I can’t imagine what the price at Gelson’s is.

At the gas station down the street, regular is $6.70 a gallon. A quarter mile away, the price is $5.70, even though the cheaper station is much nearer the freeway.

are price peaking?

There’s some evidence:

–crude oil prices have been falling recently, even though we’re in what is normally the seasonal peak period for demand. Yes, maybe the Covid situation in China is part of the reason, but still…

–used car prices are down by about 10% from their peak in March and yoy comparisons are beginning to turn negative

–layoffs appear to be starting both in tech and in the entertainment industry

next year? is the key question, I think

For price increases to be a serious issue problem, they can’t be just one-off. They have to recur.

We know that, ex pandemic times, the trend growth of the domestic working population is >1% per year; productivity growth, basically increases in the skill of the workforce or in the tools workers use, will likely be close to the usual zero. If so, the trend in real growth in the US will likely continue to fall short of 1% …which makes it hard for me to see fertile ground for runaway price expansion.

Overall real growth in the US was 5.7% in 2021, and will likely be >2% this year. The Conference Board is projecting zero real growth in 2023. The last two years, then, are similar to the pre-pandemic situation, in which the Fed was persistently unable to get inflation to stay at or above 2% yearly.

If not inflation, what will be the key issues for the domestic stock market next year?

More tomorrow.

This, one of the many old saws that spout from the mouths of professional investors and investment advisors, is about how to achieve stock market success. It’s also an observation about the behavior of US stocks as the economic cycle progresses.

The turn from bearish to bullish tends to take most investors by surprise. Because of this, the first evidence of a change in the current bad fortune tends to result in a tectonic rush to exit defensive positions (whose main virtue may be that they won’t go down much) and to acquire beaten-up cyclical growth names.

Historically, a disproportionately large part of the up that occurs in the new cycle will happen during a small number of very strong days during this transition. This all comes well in advance of confirming evidence in company quarterly earnings reports–and also well before investors–retail or professional–who have raised large amounts of cash or otherwise assumed a very defensive position can convince themselves to react.

Why do things happen this way? I’m not 100% sure.

–one part is certainly relative risk/reward. If defensive stocks are very pricy (so arguably they won’t go up a lot) and more economically sensitive names are really beaten down (and arguably can’t decline much more) it makes sense to take money out of the first group and put it into the second. As first movers act, the relative value relationships change and buyers who were waiting in the wings emerge

–another may be information, high- or low-quality, that radiates out from the world at large (we’re reopening/expanding) or work (we’re hiring/bonuses are back) or just about anywhere else

–for a mutual fund manager, a surge in inflows is typically a sign of at a top for fund performance; a rash of redemptions usually means the opposite

–a typical bear market lasts a year or so

I think we’re more or less in this situation now now.

What I see:

–measured by the S&P 500, the market has fallen about -28% from its high in December 2021 to what may be the ultimate lows this September. The decline in NASDAQ has been more like -35% over the same span. The S&P performance is in the range of a garden variety down market; NASDAQ is a bit worse. The clear, and unusually deep, losers in this market have come from a set of “concept” stocks like those held in ETFs like ARKK, which is off by 70% from its January 2021 high.

There have been three post-WWII bear markets deeper than this one has gotten so far:

—1972-74, which featured the collapse of the post-WWII financial order + the first oil shock + the bankruptcy of the UK; S&P lost 49%

—2007-09, the Great Financial Crisis, with massive fraud by bank employees threatening the solvency of global banking system, causing world trade to grind to a screeching halt, triggering widespread layoffs; S&P lost 57%; and

–the aftermath of the internet bubble in 2000; during which the S&P lost 49%.

The first two of these situations were, to my mind, clearly far worse economically than where we are now. The Internet Bubble comparison is harder to judge.

–what’s similar between IB and today:

—a high level of tech-related speculation, with subsequent market collapse;

—a 25% rise in the crude oil price from mid 1999 to end 2000.

–what’s different:

—– substantial fraud in internet stocks–Henry Blodget of Merrill Lynch, most heralded internet analyst of that time, censured and permanently barred from the securities industry for issuing fraudulent research touting internet stocks;

—–newly public startups begin to run out of money;

—–massive telecom overcapacity develops quickly, as many firms rushed to create fiber optic cable network systems rendered almost immediately uneconomic by duplication and technological advance (deep wave division multiplexing);

—–accounting scandals among major companies (Enron, Worldcom, Qwest, IBM, KMart, Bristol Myers Squibb, Lucent…);

—–Microsoft found guilty of anti-trust violations;

—–2000 introduction of the euro, causing recession in much of the EU;

—–continuing recession in Japan, at that time still a major world economy;

—–9/11/2001 attacks

Summarizing what I think is the essence of Twitter’s current financial situation:

The company has recently been growing revenues–from corporate advertising–at maybe 10% a year. It is generating cash at about a $1 billion yearly rate, mostly because the issuance of $1 billion worth of new shares to workers is a prime component of their compensation.

The Musk takeover has done two things: it has added something like another $1 billion yearly drain on cash, in the form of interest expense from the $13 billion borrowed to close the deal (insiders and the banks presumably know the exact terms; I don’t); and it has considerably reduced the attraction of stock grants as a form of compensation.

Four complementary approaches to fixing the resulting financial dilemma:

–cross fingers; hope and pray everything works out

–increase revenues

–lower costs, meaning total employee compensation

–restructure the debt.

Musk’s tweet about the Pelosi family suggests that keeping advertisers happy isn’t exactly top of mind for him. Press reports suggest least some advertisers have already cut back on their Twitter spending.

Over the first half of 2022, people-intensive operating spending amounted to about $1.8 billion, about a quarter of which was stock grants of some type. This is where Musk appears to have focused for now, with mass layoffs. Even if no advertisers had second thoughts about a Musk-led Twitter, my back of the envelope calculating says that replacing stock grants with money would have left TWTR without much cash, if any.

The banks who lent Musk the $13 billion in cash he needed to close the TWTR deal must have known this.

My mind keeps going back to a banking case I studied in business school. A consortium of international banks lent the government of New Zealand a bunch of money to develop an offshore oil and gas field. The term of the loan, as I recall it, was four years. But production from the field wouldn’t begin until year five. A problem? No.

The lending banks all understood that the loan would need to be renegotiated during year four, meaning another round of fees and higher interest rates. So the structure was a good thing for them. Assuming the NZ government wasn’t chock-full of dimwits, Wellington understood this, too. As it turns out, the only one mixed up about this loan was the professor who presented the case in class, who didn’t know the physical or monetary differences between oil and natural gas.

In the TWTR case, I read the company’s financials as saying that, absent revenue growth, compensation costs have got to be cut more or less in half–without any loss in company efficiency–for the banks to be comfortable they’ll get their money back with the current loan structure. My thought is that the loans are either secured by other assets of Musk’s or that restructuring is Plan B. There’s lots of talk in the financial press that the banks are trying to offload at least some of their exposure to distressed debt specialists. To my mind, this only makes sense if the lenders didn’t bother with any credit analysis before making the loan.