What’s It Worth

April 26, 2022

There are many ways to put spare cash to work, and bullish investment houses have been sticking with the theme that a recession is avoidable. Of course bearish opinions are rampant at this point as well, declaring that markets are facing everything from a ‘breather’ to a very bad recession.

The latest of the negative nellies (perhaps just one of them) is Deutsche Bank who is now forecasting a ‘deep recession … to bring inflation to heel’. The core part of their message is that interest rates will have to be raised substantially higher to reign in inflation. That seems the most likely course.

To better explain the thinking, it is important to have a few basic facts in place. First of all the US Federal Reserve is targeting 2% inflation as are many other central banks around the world. The March reading for the US was 8.5%, while Canada was at 6.7% for the same period. To be sure these are ‘official’ readings, but most consumers have experienced high inflation for basic goods for many years that seem to be unaccounted for by these ‘official’ readings. The fact is that many goods and services such as food, fuel and housing are dramatically more expensive now than they were a decade ago and those ‘low inflation’ readings were likely wrong.

In any case, these exceptional readings led some people last week to suggest that inflation was peeking. It is way, way too early to know that for sure and this week, wiser heads seem to realize that the difference between 2% and 8.5% (or 6.7%) is pretty significant. To slow inflation may require interest rates that are high (even higher than now) and for a longer time than might have been first imagined.

The markets are responding accordingly! Below is a chart showing the yield on the 10 year treasury (interest rate in red and green below) and the level of the S&P 500 (the black line) which this week is taking a beating. In the chart below you can see that rates are now at about 2.72% and the S&P 500 is at 4,175. But the last time rates were this high, the S&P was around 3,200 (around December, 2018) and this suggests that something has to resolve, either rates down or markets down or maybe a bit of both.

This leads me to an analysis that is becoming more common over the past few days. Bulls are intent on believing that interest rates won’t go up as high as the markets may be pricing in. This theme has been discussed by some leading thinkers, including David Rosenberg (Globe and Mail, April 26, 2022), Cathy Wood (Bloomberg, April 23, 2022) and more than a few economists, money managers and prognosticators. It is vain to disagree here without explanation, but I disagree strongly.

To be clear, the Federal Funds rate is not the same as the 10 year treasury rate. The Fed funds rate is currently at just 0.33 and the target rate is currently 0.25 – 0.50%. Obviously that is a long, long way from 2.7% but businesses and consumers pay a much higher rate to accommodate the risk of loss.

No matter which side of the argument you fall on, there is every indication that interest rates will be going much higher than they are right now. That will slow the economy, it will reduce values of many assets, particularly those acquired through debt financing and it will probably take many quarters for those effects to kick in.

That leads to the question of ‘What’s it worth?’ Anything really. Today people are paying more than ever for shelter, food, fuel which are necessities, but the price of many items besides financial assets have gone into crazy territory.

Cars are nearly impossible to get and used car prices are rising. One of the hottest stories in the market today is Tesla. They sell battery powered cars and those cars, even for the cheapest available model, sell for $58,000 before options. People continue to buy them, convinced the $2,000 a year savings on fuel justifies a $30,000+ premium for a car (ignoring the ‘save the planet’ argument completely here).

Before the pandemic you could rent a car for $50-60/day. Today those same cars cost $80-120/day. A simple hotel room? Pre-pandemic about $100-120, Today $140-170. A meal for two at a restaurant? Pre-pandemic $40-50 and today $60-90. But the premium over what things are actually worth is likely to cause problems throughout the economy.

Much of what is paid has been going to middlemen forever. The food cost at a restaurant is typically 20-35% of the cost of a meal, depending on the venue. If the price of a meal was $40, then a consumer was paying $26-32 for the service and ambiance of a restaurant. Today, that number appears to be closer to $39-48. That doesn’t include travel, parking, tips, etc. As consumers get squeezed, it seems likely that premium will not be a good value and consumption will decline.

Another example would be a t-shirt. A number of studies have shown that a typical t-shirt costs between $2 and $5 to make. A cheap t-shirt sells for $20 while a polo shirt might sell for $100 or even $250 for some brands. It is difficult to understand how these prices are reached but there is a significant risk of valuations being reset as consumers come to terms with ‘expensive everything’.

In markets we are seeing this happen already. Two well known examples of valuations being squeezed are shown below. Facebook is off 50% since last summer and Netflix is off 70% since Haloween. There are plenty of companies where the damage is even worse.

Facebook has lost almost 50% of its value since last summer
Netflix has lost 70% of its value in six months

A quick scan of the market found over 300 companies that are down more than 70% over the past six months, and a few hundred more down more than 70% over the past year. A natural question then would be what is a company worth?

The answer is long, but here are two key ideas that aid investors in understanding market direction. The first idea is market breadth. Markets are made up of thousands of companies, but if fewer and fewer are participating in the rally, then breadth declines, leaving the select few winners to support averages, earnings estimates and more.

As markets weaken, investors tend to coalesce around the ‘best’ companies as protection against risk. The smaller, less successful, and less diversified companies often get sold in favor of these larger, faster growing companies. As breadth declines, the likelihood of a significant decline in markets (and their key metrics) increases.

One measure of breadth is the number of issues advancing vs. the number declining. Here is a weekly chart showing what that line looks like following today’s market rout. Breadth has been declining steadily since November of last year. One could even argue that it should start to turn up it is so unusually bad!

The second idea is participation. Fewer and fewer people, indeed companies are able to adequately participate in the everyday aspects of consumerism. Stretched budgets, COVID shutdowns and now supply chain constraints are causing difficulties with normal operations designed for the prior 30 years and the ‘global economy’ that is arguably now ending.

With this in mind, it is reasonable to expect that the few, large, profitable companies will not be able to support valuations that comprise indices. Not all of the companies will continue to contribute to the economy in a positive way either. This week alone a number of companies have announced layoffs of hundreds of employees (Canopy Growth – 250; Robinhood – 350; Nektar Therapeutics – 500; Novartis – ‘thousands’).

A similar effect should start to take hold in the general economy as an ever shrinking group of middle and high income earners can no longer support the spending required to keep the economy growing. Along with declines in asset prices (which generally encourage reductions in spending), and increases in costs due to inflation, spending will decline and equity prices will decline as revenue and earnings targets are lowered.

This space will continue to suggest great caution until figuring out what things are worth can be done with reasonable confidence. The simple analysis of ‘it’s cheaper than last month or last year’ is not adequate given the amount of money that governments have thrust into the financial system. The reduction of those assets will require reassessing valuations.

While rate increases may indeed slow sometime in the future, it won’t stop that great sucking sound of money leaving as governments normalize the financial world. That could take some time, so enjoy your summer.

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