2022 never ended

Good morning. The January personal consumption expenditure report sent Treasury yields bouncing higher on Friday; the Fed’s favourite measure of inflation accelerated versus December, deepening the impression that early successes against inflation have now stalled. The economist Jason Furman points out that core PCE has changed little over the past year, and gave a blunt summary: “We have made little if any progress on inflation. There is little if any reason to expect a large slowdown going forward.” He thinks that the Fed should raise rates by 50 basis points at its next meeting, and signal a 6 per cent terminal rate. He’s in the minority there. Plenty of people are downplaying the January numbers on the basis of warm weather and the tendency of prices to pop at the new year. Let us know which side you are on: [email protected] and [email protected]. 

The same damn thing, over and over

My plan for today was to write about what went wrong in markets during the week I was away. But looking at the data, it became clear that last week’s decline was simply a continuation of the decline that reaches back to the beginning of February, and that this decline is just another iteration of a repeating pattern that goes back to the market peak in the final days of 2021.

The story is, by this point, totally boring. Signals of economic strength and persistent inflation predominate, Treasury yields rise, and stocks fall. Alternatively, growth and inflation appear to be moderating, yields fall, and stocks go up. Back and forth we go. I mean, for heaven’s sake, look at this chart of the S&P 500 plotted against inverted 10-year yields:

Those two lines are, for practical purposes, the same line. Investors are trapped in some sort of Greek myth. For their sins in life, they are doomed to a financial underworld in which the only thing that matters is the inflation outlook, which cannot be predicted. Every time they think they have it figured it out, the data reverses, and they are out of position again.

We all take our bets on where and how this miserable cycle stops. Unhedged’s bet has been that inflation will be hard to bring down all the way to the Fed’s target, so the central bank will have to keep policy tighter for a long time, and that tightening financial conditions will grind earnings and multiples down. So we’ve looked smart in the last three weeks, just as we looked dumb in the preceding two months. We prepare to look dumb again before long, probably multiple times, before we can get off this ride.

The grindingly familiar pattern repeats at the sector level. Here is S&P 500 sector performance from the start of this year through the second of this month:

And here it is in the last three weeks:

The winners became the losers, as they always do. Big, “high duration” tech and growth stocks spread across communications (Google, Meta), info tech (Apple, Microsoft), and consumer discretionary (Amazon, Tesla) gain most when inflation looks weaker, only to lose the most when it looks stronger. Rate-sensitive real estate follows along.

The pattern in the other seven sectors appears to be less clear. The classic defensive sectors (staples, healthcare, utilities) which trailed under a softer inflation outlook did better recently, but only marginally. They still fell. It looks like investors are responding to the spectre of higher rates by reducing risk generally, rather than shifting into defensive stocks in preparation for recession. Indeed, cyclical sectors (energy, materials, industrials, financial) basically tracked the index both up and down.

But looking at the performance of individual stocks, the standard story (inflation higher → higher rates → recession → buy defensives) asserts itself. Looking at the 50 largest stocks in the S&P, only 11 have turned in positive performances since February 2. Of these, seven were classic defensives (Merck, AbbVie, Pepsi, Raytheon, UnitedHealth, Walmart, and Coca-Cola).

Unhedged has been writing about this pattern a lot for almost a year and a half now. We wish there was another broad market narrative that mattered, but there really isn’t one that we can see. We thought that with the end of 2022, rate and Fed policy expectations were starting to stabilise, and we could move on to other matters. But as it turns out, 2022 never ended.

One important thing has changed. Earnings estimates have come down as analysts have acknowledged that sales growth is slowing and margins are tightening. In theory, this should take some of the downside risk out of stocks. But all the same, investors’ fates are still lashed firmly to the path of inflation and the Fed’s response.

Uncle Warren and share buybacks 

Reading Berkshire Hathaway’s annual letter is an excellent tonic for depressing thoughts like the ones aired in the previous section. Of course you can’t predict where inflation is going over the next year. So don’t try. Just buy businesses with trustworthy managers and strong competitive positions. Such businesses are likely to compound earnings in real terms over time. Pay reasonable prices for them and you’ll do fine in the long run. That’s the message, every year, from Warren Buffett and Charlie Munger.

Buffett also understands how stock buybacks work, which a lot of people don’t. This year he wrote:

The math isn’t complicated: When the share count goes down, your interest in our many businesses goes up. Every small bit helps if repurchases are made at value-accretive prices. Just as surely, when a company overpays for repurchases, the continuing shareholders lose.

This is correct. Look at it this way: after a share repurchase, the investors own more of the company, but the company has less cash. This is a good trade only if the cash went to buy something at a fair (or better) price.

I think Buffett pushes a little to hard against critics of share buybacks, though, when he writes that:

When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue

That italicised “all” is doing a lot of work. I think that many buyback programs do create value, but that a majority destroy it. I’m not sure I can prove this (though I will give it a serious try at some point) but my guess is that something over half of buybacks destroy value.

My argument would go like this:

• Part of the reason that companies do buybacks is that they increase earnings per share, and executives’ pay is often linked directly or indirectly to EPS. Importantly, buybacks boost EPS even when they are completed at non-accretive prices, that is, when companies overpay for their own stock.

• When companies’ stock prices are high, investors are happy and managements’ capital allocation decisions tend to go unquestioned. So managements are free to overpay for their own stock, destroying long-term value.

• As a result, buybacks are procyclical. Companies do more of them when times are good and stock prices are high — the very moment when buybacks are most likely to destroy value.

But, as I said, this is just an accusation on my part. I’d have to grind through a load of data to prove it. Maybe someone has done this already? If you’ve seen a good study, let me know.

One good read

Migrant children working adult jobs for major American companies.