The Bear Strikes Back?

SEPTEMBER 30, 2023

The third quarter was another in which, with the sole exception of energy stocks and some commodity futures, cash was king. Stocks are also in negative territory for all of 2022-2023 to date, which provides further evidence of a secular bear market. If we are still in a secular bear market, and not in a new bull market as most commentators thought at the beginning of the quarter, then there could be more trouble to come.

The capitalization weighted S&P 500 is still positive year to date. This is entirely due to the multiple expansion of a few stocks and has not been based on advancing earnings. Only 2009 and 2020 exceeded the multiple expansion of this year through June. The equal weighted S&P 500 year to date has been flat.

We will discuss the top seven stocks driving the capitalization weighted index below.

Even if energy stocks are “overbought” after rising 58% over the last two calendar years, they remain an unusually small percent of the S&P 500.

Foreign stock markets were also almost uniformly down. The major exception was Turkey, where Turks were fleeing fixed income because of rampaging inflation and putting their money into stocks because it seemed safer than fixed income. This is similar to what happened in Germany during the infamous inflation of the early 1920’s. Usually inflation damages stock prices, but there are circumstances in which the opposite happens, which should be kept in mind.

The Chinese market was among the laggards, as it had been in the prior quarter. The Chinese government adopted the novel solution of reducing available  information about companies as well as about the economy.

Even in the U.S., long term bonds had the worst return for the quarter and are heading for the first three-year loss since the 18th century. The standard 60/40 asset allocation, in which bonds are supposed to provide protection against stock variability, is now increasingly questioned. As investors sell long bonds, the chances of appreciation there improve.

As Jim Grant has noted, some of the longest maturity bonds, such as the century bonds offered a few years ago by European countries, are now down 60% or more. Zero coupon strips of such bonds are down more than 90%. Buyers of such bonds were not always as irrational as they appeared. In some cases, they had to buy them to meet government regulatory requirements.

Here is a recap of major markets.

 *2022-23 YTD

Bear Versus Bull

2023 opened with a continuation of the rally originating in the fall of the prior year. Was this a bear market rally? Or a new bull market? It appeared that the rally had run out of fuel by February, which remained the high until May. After the February high was finally exceeded, prices rose sharply.

The driving force at that point was the Artificial Intelligence (AI) craze. Was AI a new bubble, or a temporary bubble extender as suggested by bubble student Jeremy Grantham? As with any such phenomenon, there is always evidence both ways. Nvidia dramatically and Qualcom to a lesser degree were translating AI into revenues and earnings. Beyond those two, it was mostly expectations and hopes. Even retail chains were claiming that they too were AI companies. We remained cautious. Important new technologies usually take a decade to get going. When they do, leadership has often shifted from the early stars.

By the beginning of this last quarter, AI had helped the market reach a very high level of optimism, similar to the level seen right before the 2000 Crash. The prevailing view was that we had started a new cyclical bull market within a continuing secular bull market. Ned Davis Research noted that the average gain for a new cyclical bull within a secular bull has been 80%. Vanguard reported that one fifth of shareholders 85 or older had virtually all their money in stocks.

Electric car maker VinFast Auto illustrated the revival of enthusiasm. It entered the market through a SPAC merger, rose to a share price high of $82 in August, fell to $12 by this quarter end, and reached $7 most recently. Various meme stocks such as Tupperware, Rite Aid, and Yellow all had their fleeting moment of glory.

CalPERS announced in August that it was quintupling its allocation to the stricken venture capital field by $5 billion. A KKR survey showed that leading endowments had nudged up their illiquid investments to 52%.

As the quarter progressed, public markets splashed cold water on this optimism.

The Top Seven Stocks

Here is an update on price returns of the now infamous Top Seven stocks:

As these stocks appreciated, index funds became so concentrated that they began to fail the SEC test for being “diversified.” Nasdaq responded by reformulating the index in a way that reduced the top ten stocks from 50% to 40%. Microsoft and Nvidia were trimmed the most, 3% each.

For the latest quarter, some of the seven appreciated while others fell. Enthusiasm was clearly ebbing. Nvidia is now the only one of the seven whose calls are more expensive than puts. Apple has serious problems currently. Most of its production and 20% of its sales are in China, but the Chinese government is now forbidding its employees from buying iPhones and discouraging everyone from doing so. Apple stores in China are described as empty. This comes after China “persuaded” Apple to invest $275 billion in the country in recent years. As noted above, Apple’s price during the quarter fell almost 12%. Since Apple is the dominant holding of Warren Buffett’s Berkshire Hathaway, this affected that stock as well.

Some Additional Doom & Gloom

• Companies below the largest 500 in the US by sales are filing for bankruptcy at the highest rate since 2009.

• Corporate bankruptcies are up 71% from the low set in 2022.

• According to a Fed study, 37% of U.S. companies are already in financial distress and this figure is expected to rise given the Fed policy of “higher for longer.”

• Analyst Mike Green estimates that as much as 85% of junk rated companies would become unprofitable if forced to refinance immediately at current rates.

• One third of Russell 2000 companies are not profitable.

• Rates on the private credit market (not bank and not listed on a market) are now well north of 10%, which is still lower than CCC rated junk bonds. Institutional money is flooding into this area, which is often the institutional version of consumer payday lending and is not likely to end well. Private credit and leveraged loans (the lending behind leveraged buyouts) amounts to $3 trillion in the U.S. alone. 92% of leveraged loans are “covenant lite.” Covenants behind private credit are not generally available information.

• European bank loan demand is down 40%.

• An estimated half of the 1,000 smallest U.S. banks could be in financial trouble.

• Of the approximately $2.3 trillion of commercial real estate loans, half is floating and a majority of it comes due by the end of 2025. This debt is often held by smaller banks.

In the face of this, Wall St. analysts are forecasting an end to falling earnings this quarter and steady increases from here on out.

In reviewing all such gloomy information, one must keep in mind that it is not circumstances, but rather circumstances unanticipated by most investors, that move markets.

Looking Ahead

If we are indeed in a secular bear market, it will produce unparalleled opportunities to buy stocks at bargain prices. Whether or not we get these opportunities, we believe that we are well positioned to protect our clients’ portfolios against any contingency.

In the meantime, we also want to note a recent paper authored by former colleagues at Cambridge Associates suggesting that investment management and related family office fees for institutional sized investors typically fall between 1.45% and 2.25%, which sounds accurate to us. By contrast, we believe that successful long-term investors must keep their fees below 1%. Our own fees are less than half this.