Keep Emotions Low and Focus Long-Term
The Debt Ceiling Debate, Fed Rate Hikes, Regional Bank Stress, and Prognostications of a Recession - there is certainly no shortage of negative headlines irking investors and shaking confidence. Yet, as we all know, headlines are intended to have stopping power and there is little shock value in looking at the bright side or arguing for calm.
“Be Fearful When Others Are Greedy and Be Greedy When Others Are Fearful” – Warren Buffett
This onslaught of negative media headlines can raise investor fears and create the potential for emotionally driven sales. While some level of concern is valid, we suggest evaluating these headlines with a more balanced view.
Debt Ceiling Drama
As we wrote in our April 11th blog “Debt Ceiling Drama” we expect acrimonious headlines around the debt ceiling to persist until just before the actual X-date, if for no other reason to perpetuate a crisis for media ratings. What we see as lost in the negative headlines are consistent pledges from both sides that they won’t let a default happen. Still, neither side will likely concede prematurely. So, we only expect a deal, or an extension, right before the actual X-date and investors should keep this in mind while they are bombarded with day-to-day drama on the topic.
Fed Rate Hikes: Can Completion Become a Catalyst?
We believe the Fed is done raising rates for at least a few months, if not for this cycle completely. The PPI data released May 11th shows a continued cooling in inflation, down to 2.3% year-on-year, and down to 3.2% ex-Food and Energy.* The Fed has raised rates 5.00% in a short 15-month period. The U.S. economy does not behave like a speed boat that will turn quickly, but more like a gargantuan cruise ship that will take its time, but finally make the turn. We think inflation data will continue to cool over the next few months from rate actions already taken. While we don’t see the Fed cutting rates this year, we think a long pause or completion of this program will be increasingly seen as a positive for the stock market, as the risk of a continued Fed overshoot is removed.
Regional Bank Stress: Don’t Throw the Baby Out with the Bathwater
The failures of Silicon Valley Bank, First Republic and Signature Bank of New York were undoubtedly negative events for the market. However, as has been written extensively, each of these banks had engaged heavily in non-typical bank activities, that can be summed up as not correctly matching their asset duration with their liability maturities. We do not believe this behavior is typical of the vast majority of other regional banks. While most banks will feel the negative impacts of higher rates, through increased funding costs, we believe this impact will broadly impact the group as an earnings or “income statement” issue, and not a capital or “balance sheet” issue. Further, we believe this income statement damage is mostly reflected in the stock prices of these banks. For example, the S&P Regional Banking ETF (“KRE”) is down roughly 40.43% since March 1st 2023**. The average price/earnings ratio of this ETF has fallen to 6.64x and the price to book value has fallen to .77x. At the current P/E multiple, earnings could fall 33% and the group would only trade at a still low 10x P/E multiple, suggesting fears have been priced into the group.
Credit, as always, remains a long-term risk, but for now, as of 1Q23, credit metrics are nearly pristine, due to both strong performance and due to the adoption of CECL accounting, which has forced banks to build reserves to a greater extent that past cycles. We think this cyclical group is near a trough, with the vast majority offering limited downside risk and long-term opportunity for capital appreciation.
Recession: When, If, and What?
GDP for 1Q23 came in at 1.1%, a slowdown from 2.6% in 4Q22. Many economists are forecasting a sequential slowing in GDP, in line with the Conference Board’s projections of -0.6% for 2Q23 and -1.6% for 3Q22.*** While we do not make macro-economic forecasts, we would suggest investors ponder the potential depth and duration of a potential economic slowdown, and measure this against long-term investment cases and valuation levels for specific investment opportunities. We note a few observations: i) Great valuation opportunities in stocks do not present in times of clarity and calm. ii) Current investor sentiment is very negative – emotions are high. iii) Algorithmic trading, in our view, is increasing volatility, as these strategies push short term trading trends which in many cases revert after just a few days. Having a long-term investment case for one’s investment can help remove the dangers making poor emotional decisions due to the normal volatility of an economic cycle.
Keep a Long-Term Focus and Stay Opportunistic
Given the current market volatility, we think investors should keep some dry powder to take advantage of other’s potential emotional sales, keeping in mind that the greater the perceived crisis, the greater the potential bounce once resolved.
We emphasize the importance of staying disciplined, removing emotions from your decision making and sticking to your long-term goals. To pursue a long-term investment strategy, that benefits from the power of compounding, one must build the presumption of economic volatility into an investment decision. We believe that focusing a minimum three-year horizon, and selecting companies with strong financial positions and identifiable long-term growth opportunities is a sound strategy to overcome short-term economic and market volatility.
Valuation Always Matters
It is important not to let short-term volatility force an emotional sale at a low valuation. We suggest staying opportunistic to purchase companies that may be caught in an emotional and/or algorithmic selling loop, if the long-term financial position and growth strategies remain in-tact. Said differently, “Be Greedy When Other’s Are Fearful” and try not to make an emotional mistake.
Rewey Asset Management is a registered investment advisor in the State of New Jersey
Notes:
*KRE: SPDR S&P Regional Banking ETF performance information as of 5/12/23 sourced from Bloomberg. KRE ETF valuation statistics sourced from Bloomberg.
**PPI: U.S. PPI Final Demand NSA year-over-year sourced from Bureau of Labor Statistics, via Bloomberg.
***Conference Board GDP projections sourced from: Economic Forecast for the US Economy (conference-board.org)
This material is for informational purposes only and is not a recommendation or advice. Investments and strategies mentioned are not suitable for all investors. No one can predict or project performance, and forward-looking statements are not guarantees. Past performance is not indicative of future results. Investing involves risk, including the loss of principal.
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