Loosely Tight Conditions

Financial conditions are too loose for inflation but too tight for financial assets near record valuations.

If this is the beginning of another decade of higher-than-average cost of capital, equity markets are yet to reflect these changes in fundamental multiples.

Since 1900, there have been only five decades that the total real return for US stocks was negative. In fact, they were all deeply negative.

Three of these periods happened during inflationary eras. The other two occurred at a time when valuations of US equity markets were at historical levels. Today, we have both setups at the same time.

Investors have been conditioned to value financial assets as if they were about to experience another disinflationary decade.

As shown in the last chart, the last time we had a long period of higher-than-average cost of capital was in the 1910s, 1940s, and 1970s.

While each had its own unique circumstances, fundamental multiples for stocks significantly contracted over all those decades.

To be specific, the average decline was nearly 50%.

More importantly, note that CAPE ratios were at single digits at the end of two periods, and around 10.5x for the '40s.

What if today’s multiples were to reach similar levels by the end of this decade?

Let's do an exercise with different assumptions:

The last decade, the 2010s, marked one of the best times for corporate profit growth in the last century. By the end of that period, 10-yr cyclically adjusted earnings had grown by 61%.

If we were to experience the same robust increase this time around, assuming a 10.5x CAPE ratio, the S&P 500 would be trading 55% lower by the end of this decade.

While this may sound extreme to some... What if we use a 15x CAPE instead?

That would take the S&P 500 about 34% lower than its current prices.

OK, what if we apply the corporate earnings growth rate that occurred during inflationary decades instead?

Using professor Robert Shiller’s data:

From the beginning to the end of those periods, the average increase in the 10-yr cyclically adjusted earnings was close to 16%. In that case, assuming a 10.5x CAPE ratio again, US stocks would be down approximately 67%. Alternatively, using a 15x multiple, equity markets could be down as much as 52%.

While these declines may seem excessive, they are simply a function of historic multiples in a high cost of capital environment, like we have today.

Additionally, today’s multiples are over 70% more expensive than they were when each of those inflationary decades began.

To be clear, these scenarios didn't consider the potential impact of a contraction in EPS.

What if the pressure from rising labor costs becomes structural, margins compress from record levels while most analysts on Wall Street expect profits to grow at double digits in 2 years?

Nominal corporate earnings have been trending in an upward channel for 70 years. Every time profits reached the upper band of this range, an earnings recession followed.

We are at a similar peak-level juncture again today while analysts continue to be overly optimistic.

The current real growth in corporate earnings for this decade is on pace to be the 2nd largest in history, which is right behind the prior decade’s performance.

Outside of the 2010s, the other 2 times we had outstanding long-term increases in profits were:

?? 1920s

?? 1990s

Both periods preceded severe earnings recessions.

We believe the 2010s marked another decade’s peak for corporate profits and today’s growth is completely unsustainable. Earnings are poised to turn negative over the next year and likely for the balance of the decade due to structural inflationary factors.

Our work shows that corporate margins are likely to be drastically reduced by a combination of key macro forces:

?? An early-stage wage-price spiral

?? Higher cost of capital

?? Rising deglobalization trends

?? A continuation of structurally rising material costs

However, despite the risk of a cyclical downturn in profits, it is important to point out that, even in real terms, corporate earnings increased on average by 13% during inflationary decades. More notably, these periods were extremely volatile for profits.

The issue today is that we are two years into the decade and corporate earnings have already grown by 23% with companies at their highest profit margins in history. That is the lagged product of unprecedented monetary stimulus that has been reversed.

The broad stock market outside of natural resource industries is historically expensive on almost all fundamental metrics.

It's one of the main reasons why the start of this decade is so unique, especially compared to the 70s when equities were substantially cheaper.

On a CAPE ratio basis, for instance, market prices are near record levels relative to 1, 3, 5, and 10-year cyclically adjusted earnings.

The only plausible way to justify the current multiples in equity markets would be if, for the first time in history, we were to experience a 50% increase in real earnings for back-to-back decades.

However, every prior speculative environment like we have today ended with significant real earnings and economic contraction.

With the monetary liquidity that drove this mania having been sharply reversed, it is hard to make a compelling case why this time will be different.

Valuations for the top-ten megacap tech stocks are still higher than they were for their comps at the peak of the tech bubble.

Credits to my partner, Kevin Smith.

Earnings yield for US stocks is now close to turning negative versus the Fed funds rate for the first time since the tech bust.

es, equity risk premia were also below zero during most of the 90s, although, those years were accompanied by very strong growth led by new technologies and the internet.

It's hard to believe that we will be entering another decade of above-average growth after one of the strongest bull market periods in history.

Corporate bonds look even more concerning. The average bond already yields less than the Fed funds rate and is now at its lowest spread in 30 years.

Why would anyone take the extra risk of owning these instruments when one can receive over 4.5% yield risk-free? This is arguably the most expensive part of today’s market.

However, the Fed is still playing with fire.

Despite the recent rate hikes, financial conditions remain way too loose. This is typical of an early inflationary cycle. The longer inflationary forces persist, the harder will be to expel them from the system.

The increase in the cost of living has exacerbated the already severe wealth-gap issues in society, unleashing what is likely to be the early stages of a wage-price spiral.

These changes are remarkably similar to what the US economy experienced in the 1970s, which became a key inflationary macro driver of that decade.

Today’s wage growth is arguably one of the largest concerns among policymakers in attempting to fight inflation. The issue is that rising labor cost is unlikely to subside any time soon with job openings at the current levels.

There are almost 2 jobs available for each unemployed people today. As shown in the second panel of the chart below, that is near all-time highs.

There has been a significant change in real wages confirming a recent upward trend. In fact, nominal wage growth is starting to move higher again despite the deceleration in inflation.

The rising labor cost pressure is likely to become another secular inflationary driver. Today’s loose monetary conditions by Taylor Rule standards are only exacerbating this macro force.

The potential for an early-stage wage-price spiral is not our only concern from an inflationary perspective. The chronic period of under-investments among natural resource businesses is yet another critical factor.

After adjusting for GDP levels, commodity producers are well over 50% below their prior peak in aggregate capital spending. The availability of raw materials follows the capital investment cycle for natural resource industries.

However, despite the higher prices in most commodities, producers have severely lagged in their development cycle for bringing new assets into production. It is happening broadly across metals and mining, energy, and agriculture.

Aggregate CAPEX for energy companies adjusted for GDP levels is still below every other depressed level in the last 30-plus years. Current levels are over 75% lower than the prior peak.

This worldwide index of metals and mining companies also shows a nearly 70% decline in capital spending from 2013 levels.

Metals of all kinds are critical to electrification, for batteries, solar, wind, and electric grid which are all at the heart of the green energy transition.

?Meanwhile, these stocks remain insanely cheap.

Gold miners have not been able to increase their revenues while the metal price remains near all-time highs.

In short, this is mainly a function of declining industry-wide production, a key part of the macro investment case for gold.

The last two secular bull markets for gold happened on the back of multi-year declines in metal production.

Today, this has been amplified by the shift toward battery metals as part of the Green Revolution.

To recall, the energy sector went through a similar issue over the last 2 years.

?As ESG mandates gained popularity, oil & gas companies became uninvestable for many institutions. Nonetheless, the energy sector still managed to have two of its best annual performances in 30 yrs.

A similar scenario is setting the stage for mining companies today. It wouldn’t surprise me if these stocks lead the market in the 12 months.

The turnover volume for smaller mining companies remains incredibly depressed. The 50-day average traded volume in the TSX Venture Exchange is currently re-testing its prior historical lows.

Such levels of disinterest in the part of the industry have often marked major bottoms in share prices. We saw a similar scenario back in 2015 and 2019. In both periods, the TSX Venture index rallied massively over the next one to two years.?

Credits again to Kevin Smith on this one:

Back to the fundamental case for the energy sector:

The recent selloff in energy stocks has set the stage for another opportunity. This sector is again trading at its most undervalued levels in history on a free-cash-flow yield basis.

Lastly, we believe we are at the beginning of an exciting long-term period for macro and value investors for 3 main reasons:

1) The unwinding of speculative bubbles with failing 60-40 portfolios and a full-blown transition from growth to value stocks.

2) The re-emergence of gold as the most credible asset to improve the quality of central banks’ balance sheets worldwide.

3) The opportunity to invest in historically undervalued commodity-related businesses at the likely early stages of an inflationary decade.

Hope you enjoyed this research piece. Have a great weekend.

-- Tavi Costa