Stocks rallied last week. The S&P 500 surged 4.7% in what was the biggest weekly gain since June. The index is now up 4.9% from its October 12 closing low of 3,577.03. However, it’s still down 21.8% from its January 3 closing high of 4,796.56.
When markets are as volatile as they have been, it’s easy to get caught up in all the things that are going right or wrong at the moment.
And while there’s nothing wrong with keeping current on the present, this is not the right mindset for long-term investors in stocks.
“Do not invest in the present,” Stanley Druckenmiller, the legendary hedge fund manager currently running Duquesne Family Office, said. “The present is not what moves stock prices.”
Druckenmiller noted that this is his No. 1 piece of advice for new investors.
“I learned this way back in the 70s from my mentor [Speros] Drelles. I was a chemical analyst. When should you buy chemical companies? Traditional Wall Street is when earnings are great. Well, you don’t want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there’s overcapacity and they’re losing money. What about when they’re losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it’s going to be in 18 to 24 months as opposed to now. If you buy it now, you’re buying into every single fad every single moment. Whereas if you envision the future, you’re trying to imagine how that might be reflected differently in security prices.”
This is theoretically sound as theory says the value of a stock should reflect the present value of a company’s future cash flows.
Druckenmiller is talking about picking stocks. But I think his still serves as a good framework for broadly diversified investors processing macro information coming from economic data and earnings announcements.
The labor market is strong 💪
One big theme of late has been the strength of the labor market. Specifically, the elevated level of job openings signals the need to hire, and the depressed level of layoff activity signals the desire to hang on to employees.
Consider these quotes from recent earnings calls (via The Transcript and RBC Capital Markets):
“I would note at this point, based on our Q3 performance, we have seen net hiring among our customers. So, we have not yet seen an emergence of recessionary impact in our commercial book of business.” – UnitedHealth Group
“We’re seeing positive staffing trends with 11 straight weeks of net pharmacist head count increases.” – Walgreens Boots Alliance
“We are not making major cutbacks across the plant…We don’t see any reason for great draconian measures.“ – Morgan Stanley
Bloomberg reported that Goldman Sachs, Morgan Stanley, Citigroup, JPMorgan Chase, and Bank of America all increased their headcounts in Q3.
Similarly, the past week’s high-level economic reports broadly confirmed these anecdotes. Initial claims for unemployment insurance benefits fell last week and continue to trend at low levels. The Federal Reserve’s October Beige Book said that employment “continued to rise at a modest to moderate pace in most Districts.“ Manufacturing business surveys from the NY Fed and Philly Fed each indicated employment was up in their respective regions in October.
What all this staffing means for the future 🤔
The resilient labor market suggests that demand in the economy continues to be robust.
But that’s the present.
What about the future? What does this mean 18 to 24 months down the road?¹
I think there are at least two basic scenarios to consider.
Bearish scenario: The economic lull we’re in eventually evolves into recession and we have an extended period of weak demand. Companies that are currently increasing hiring or refusing to layoff workers could see a sharp drop in earnings as weak revenue runs into high labor costs, and profit margins get crushed.
Bullish scenario: The economic lull we’re in proves short-lived, and growth soon accelerates again. Companies that held on to employees or grew head counts today may not need to compete aggressively for workers in what should be an increasingly competitive labor market. Because they already have extra capacity, these companies will benefit from operating leverage as revenue growth comes with expanding profit margins, which amplifies earnings growth.
What actually happens depends on where the economy heads, which itself is not an easy thing to predict.
But I can’t help but think that given the current state of things, the outlook favors the more bullish scenario. Why? Because the message from the economic data and corporate America is that demand continues to outpace the capacity to supply. Consider this quote from the Fed’s October Beige Book: “Overall labor market conditions remained tight, though half of Districts noted some easing of hiring and/or retention difficulties. Competition for workers has led to some labor poaching by competitors or competing industries able to offer higher pay.“
And consider this from Domino’s: “Staffing remains a constraint, but my confidence in our ability to solve many of our delivery labor challenges ourselves has grown over the past few quarters.”
So demand would have to fall considerably before companies find themselves with too much costly idle labor.
Let’s check back in 18 to 24 months.
The bottom line: Stocks are a discounting mechanism, pricing in what’s expected to happen and not what’s currently happening. Whether it’s 18-24 months out or 20 years out, being in the stock market is about betting on a better future that has yet to be realized and priced in. Now, it’s not particularly clear what’s to come in 18-24 months. (The lesson of the past 18-24 months is that things can certainly go wrong.) But long-term history is very consistent in teaching us that the long-term future always turns out to be better than what we are experiencing today.
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Reviewing the macro crosscurrents 🔀
There were a few notable data points from last week to consider:
🚨 Recession warning sign. The Conference Board’s Leading Economic Index2 fell in September. The six-month average change was -0.5%, a reading that’s historically associated with recessions. From The Conference Board’s Ataman Ozyildirim: “The US LEI fell again in September and its persistent downward trajectory in recent months suggests a recession is increasingly likely before yearend. The six-month growth rate of the LEI fell deeper into negative territory in September, and weaknesses among the leading indicators were widespread. Amid high inflation, slowing labor markets, rising interest rates, and tighter credit conditions, The Conference Board forecasts real GDP growth will be 1.5% year-over-year in 2022, before slowing further in the first half of next year.”
Meanwhile, Bloomberg economists estimate there’s a “100%” probability that the U.S. economy will have entered a recession by October 2023.
📈 Mortgage rates keep climbing. According to Freddie Mac, the average 30-year fixed-rate mortgage rose to 6.94%, the highest level since April 2002.
📉 $2,500 monthly mortgage payment gets you less. Surging mortgage rates and still-high home prices have made buying a home unaffordable for many. According to Bloomberg’s Michael McDonough, a $2,500 monthly mortgage payment could get you a $756k home in February 2021. Today, it gets you a $455k home.
🏘 Home sales continue to fall. According to the National Association of Realtors, sales of previously owned homes fell 1.5% in September to an annual rate of 4.71 million units. From NAR chief economist Lawrence Yun: “The housing sector continues to undergo an adjustment due to the continuous rise in interest rates, which eclipsed 6% for 30-year fixed mortgages in September and are now approaching 7%. Expensive regions of the country are especially feeling the pinch and seeing larger declines in sales.“
🏘 Home prices continue to fall. The median price of homes sold fell to $384,800 in September, down from the June high of $413,800. However, the median price is still 8.4% higher from last year’s level. To better understand why this government inflation data appear to lag these trends, read this.
🔨 Home construction continues to cool. According to the Census Bureau, the pace of housing starts September fell 8.1% from August and 7.7% from year ago levels. The pace of new building permits increased 1.4% from the month prior, but was down 3.2% from a year ago.
🛠 Builder sentiment goes deeper into the dumps. From the NAHB: “In a further signal that rising interest rates, building material bottlenecks and elevated home prices continue to weaken the housing market, builder sentiment fell for the 10th straight month in October and traffic of prospective buyers fell to its lowest level since 2012 (excluding the two-month period in the spring of 2020 at the beginning of the pandemic).“ From NAHB chief economist Robert Dietz: “While some analysts have suggested that the housing market is now more ‘balanced,’ the truth is that the homeownership rate will decline in the quarters ahead as higher interest rates and ongoing elevated construction costs continue to price out a large number of prospective buyers.“
🛠 Manufacturing has been holding up. Industrial production activity increased by 0.4% month over month in September.
🛠 But manufacturing surveys are more cautious. According to the New York Fed’s October Empire State Manufacturing Survey, manufacturing activity is contracting in the New York area.
And according to the Philly Fed’s October Manufacturing Business Outlook Survey, manufacturing activity is contracting in the Mideast U.S.
Here’s JPMorgan on the divergence between the hard industrial production data and the soft manufacturing survey data: “While past experience suggests this gap is most likely to close with activity sinking to mirror the message from the surveys — all the more so given the tightening of financial conditions — the surprising support from global goods demand gives us pause.“
💼 Unemployment claims remain low. Initial claims for unemployment benefits rose to 214,000 during the week ending Oct. 15, down from 226,000 the week prior. While the number is up from its six-decade low of 166,000 in March, it remains near levels seen during periods of economic expansion.
👍 Small businesses plan to hire. According to BofA, a growing percentage of small business owners plan to hire over the next 12 months.
🤾♀️ Less work, more leisure. The NY Fed recently looked into how Americans have changed the way they use their time since the emergence of COVID-19. From their blog post: “First, we find a substantial fall in time spent working; the decrease in hours worked away from home is only partially offset by an increase in working at home… Second, we see notable increases in leisure time and sleeping. The rise in leisure was particularly pronounced among younger Americans, who reported spending more time at social events, eating at restaurants or bars, and exercising. Older age groups, on the other hand, tended to allocate more time to nonmarket work, such as activities related to childcare, the maintenance of the household, repairs, and meal preparation.“
👶 Pandemic “baby bump.” From the NBER: “Although fertility rates declined in 2020, these declines appear to reflect reductions in travel to the U.S. Childbearing in the U.S. among foreign-born mothers declined immediately after lockdowns began — nine months too soon to reflect the pandemic’s effects on conceptions. We also find that the COVID pandemic resulted in a small “baby bump” among U.S.-born mothers. The 2021 baby bump is the first major reversal in declining U.S. fertility rates since 2007 and was most pronounced for first births and women under age 25, which suggests the pandemic led some women to start their families earlier. Above age 25, the baby bump was also pronounced for women ages 30-34 and women with a college education, who were more likely to benefit from working from home.“
💰 Passive investing savings pile up. From S&P Dow Jones Indices: “Among the many benefits of indexing is its low cost relative to active management. As indexing has grown, investors have benefited substantially by saving on fees and avoiding underperformance. We can estimate the fee savings each year by taking the difference in expense ratios between active and index equity mutual funds, and multiplying this difference by the total value of indexed assets for the S&P 500, S&P 400, and S&P 600. When we aggregate the results, we observe that the cumulative savings in management fees over the past 25 years is $357 billion.“
👍 Q3 earnings are beating expectations. From FactSet, “For Q3 2022 (with 20% of S&P 500 companies reporting actual results), 72% of S&P 500 companies have reported a positive EPS surprise and 70% of S&P 500 companies have reported a positive revenue surprise.“
👎 But 2022 and 2023 earnings expectations are coming down. Analysts’ estimates for full year earnings in 2022 and 2023 continue to slip.
👍 But but: Despite the downward revisions to 2022 and 2023 earnings estimates, analysts still expect earnings to grow 6.7% year-over-year in 2022 and 7.3% in 2023.
Putting it all together 🤔
Tighter monetary policy from the Federal Reserve continues to have an unambiguously negative impact on the housing market as higher mortgage rates cool activity. But it’s also having the central bank’s intended effect of cooling prices.
Manufacturers are cautious about the outlook for the economy, but actual activity remains resilient.
Labor market indicators, meanwhile, continue to hold up.
So prepare for things to cool further given that the Fed is clearly resolute in its fight to get inflation under control. Recession risks will continue to intensify and analysts will continue trimming their forecasts for earnings. For now, all of this makes for a conundrum for the stock market and the economy until we get “compelling evidence” that inflation is indeed under control.
The good news is there’s still a strong case to be made that any downturn won’t turn into economic calamity. This is corroborated by the fact that there’s been no collapse in industrial activity or consumer spending, which has been supported by the resilient labor market and rising incomes.
1. In his quote, Druckenmiller speaks about his time as an analyst covering chemicals, a relatively capital intensive industry. Companies in this business invest in very expensive facilities and equipment with the intention of using it all for years. These costs don’t go away during downturns. Labor costs are a bit different in that companies have the option to lay off workers.
2. Here’s more detail from the Conference Board: “The LEI is a predictive variable that anticipates (or “leads”) turning points in the business cycle by around 7 months… The ten components of The Conference Board Leading Economic Index® for the U.S. include: Average weekly hours in manufacturing; Average weekly initial claims for unemployment insurance; Manufacturers’ new orders for consumer goods and materials; ISM® Index of New Orders; Manufacturers’ new orders for nondefense capital goods excluding aircraft orders; Building permits for new private housing units; S&P 500® Index of Stock Prices; Leading Credit Index™; Interest rate spread (10-year Treasury bonds less federal funds rate); Average consumer expectations for business conditions.”
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