Is The Bottom Almost Here?

[TwoCitiesCapital]

Philly Fed area Manufacturing outlook report came in at -24 versus the prior months -9. 

 

Primary detractors were new orders and declines in average work week hours. Shipments and employment remained positive, but were somewhat weaker MoM. 

 

The -24 level is the lowest reading since May 2020. Prior to 2020, the last time it was at these levels was 2008/2009. 

[changegonnacome]

26 minutes ago, Gregmal said:

ea between ABNB and the MSG earnings calls, I’m not sure there’s any signs of a struggling consumer…at least if you are picking your spots wisely. 

 

Yep Its exactly like I would expect - and we talked about before........middle to high income earners are able to be navigate the cost inflation (1) cause their household budgets have room for a little upward movement in prices (2) the've the ability to negotiate & secure CPI vicinity salary increases.

 

Businesses that provide services (and credit) to more sub-prime/lower income customers are feeling it from what I can see..........MSGE does not sell $40 vodka sodas to these folks!!!

 

Picking your spots right now is 100% the right way to navigate things!

 

Edited February 16, 2023 by changegonnacome

[Viking]

1 hour ago, nafregnum said:

 

As opposed to "What's the Fed gonna do next?", I think this kind of "macro" has to be at least as actionable as weather reports following the path of a hurricane.  Sure, a hurricane can change direction and make landfall somewhere else, but that doesn't mean weather reports are useless noise.

 

So, as mortgage rates in Australia and Canada begin to climb, what will happen?

 

  - Mortgages become more expensive.  Real estate prices see downward pressure.  Some areas suffer more than others, depending on demand as people move to where they can afford to live.

  - If rents go higher, do people move further from big cities out into the suburbs?

  - In general, people have less money to spend?

  - Maybe foreclosures go up?

 

In the aggregate, what behaviors change when people are feeling the pinch?

 

  - Less eating out at restaurants?

  - Cut back on travel plans?

  - Start shopping at DollarTree and Walmart type stores?

  - More people do their own car maintenance?

 

Some of you could add some good insights to add to these bullet points based on your wide reading and long experience.  I remember reading that Allan Mecham (who used to run a fund called Arlington Value) wrote that AutoZone would benefit during downturns because as people have less money to spend, those who know how will start doing their own oil changes.  I always thought that was an interesting detail to notice, and I often find myself trying to think of new insight like that.  

 

If a mortgage debt hurricane is threatening Vancouver and Australia, how would you prepare for the financial storm? 

In Canada anyone with a mortgage or line of credit is now (or will be shortly) paying much, much more in interest expense. $100/month more doesn’t matter. $1,000/month more does matter. $2,000/month matters even more. This is an after-tax increase in expenses. At the same time food costs are way up. Insurance costs are way up. Flight costs are way up. Vehicle costs are way up (if you can even find one). Etc, etc. Wages? Up a little.
 

What does it all mean for an investor? Not sure. It will likely take years to fully play out. But given the magnitude of the impact, there will be big winners and losers. And that is the fun part about investing… skate to where the puck is going… 

—————

Having said all that, Canada has minted tens of thousands of millionaires over the past decade (real estate). House prices have come down over the past year; but real estate prices are still much higher that what they were 2 short years ago. That wealth is real and those people are spending. 
 

So i am not doom and gloom. I am remain very optimistic. 2023 is shaping up to be another super interesting year. 

 

Edited February 16, 2023 by Viking

[thepupil]

if you want to find the companies that are struggling in this environment. middle market buyout levered to the gills with floating rate debt is where its at. 

 

~40% of companies seeing EBITDA* decline. 100% of companies seeing interest expense rocket up. 

 

*and that's PE owned company reported EBITDA. how many you think are super aggressive in trying to show EBITDA growth?. 

 

 

 

Quote

 

Shrinking Profits at Private Borrowers Sound Early Credit Alarm

• Middle-market firms see revenue and earnings growth diverge
• Lincoln says loan values drop to lowest since the pandemic

By David Brooke

(Bloomberg) -- 

The Teflon gleam of the private credit market is showing cracks as rising interest rates and inflation cut into profits at middle-market borrowers.

While experiencing strong revenue growth last year, closely-held companies that typically rely on financing from private credit funds have been hit by a contraction in profit margins due to higher debt service and labor costs, which may lead to earnings declines in 2023, according to Chicago-based investment bank Lincoln International.

Around 80% of private middle-market companies tracked by Lincoln increased their revenue in 2022, yet only 60% of those also reported growth in earnings before interest, taxes, depreciation, and amortization. Median revenue growth was 15% for the year, while earnings expanded only by 9%, according to Lincoln.

“It is remarkable that four in every five private companies experienced revenue growth, but only about half experienced Ebitda growth,” said Ron Kahn, co-head of Lincoln’s valuations and opinions group. “If portfolio companies are unable to pass along costs through price increases and sustain demand tailwinds, we will likely start to see Ebitda declines across the market.”

The Federal Reserve’s rate-hike campaign is adding to private borrowers woes. Loans provided by private-credit lenders are tied to floating rate benchmarks and borrowers are typically able to lock in the reference rate for 90 days.

That means many have only started to feel the full impact of recent interest rate increases on their earnings. Tuesday’s US consumer price index report for January made clear that inflation persists, and Fed officials have pledged to raise rates as needed to combat rising prices.

Values Decline

Public asset markets, of course, have been battered for about a year by rising rates and sticky inflation. But the erosion in profit margins is a wake-up call for the opaque, $1.4 trillion private credit arena after a decade of steady growth amid benign credit conditions. 

There are other worrying signs. The fair value of private credit loans tracked by Lincoln decreased to 96.3 cents on the dollar in the fourth quarter of 2022 — its lowest since the pandemic. Default rates almost doubled last year to 4.2% from 2.2% in 2021, according to Lincoln. 

Lincoln tracks around 900 companies with median Ebitda of approximately $30 million to $35 million. Because these companies are typically owned by private equity and rely on private lenders for financing, their performance is a closely watched measure of the market’s overall health.

Lenders such as Ares Management Corp. and Golub Capital say they’re well aware of the challenges faced by the companies they lend to and that they are preparing for tougher days ahead.

“I bundle a lot of these operating concerns for companies into the same bucket, whether it’s the need to pass through price increases, labor shortages, production challenges or supply chain issues,” Kipp deVeer, chief executive officer of Ares Capital Corp., a business development company, said on an earnings call last week. “It’s just harder running companies these days.”

 

 

 

Quote

Closely held midsize companies in the US are being challenged to pass on the costs of rising inflation and higher interest rates to protect their own bottom line new data show. 

Earnings growth trailed revenue expansion for the fourth consecutive quarter as last-twelve month revenue for middle-market companies grew 4.7% on average in the second quarter, while earnings before interest, depreciation and amortization -- or Ebitda, a critical measure for debt-laden firms -- was recorded at 2.3%, according to a report Monday from investment bank Lincoln International. 

Year-to-date, firms saw a 13% increase in revenue growth compared with the same period in 2021, yet Ebitda growth in that period was just 0.6% with margins contracting 2.3% on average. 

“Though it is remarkable how well demand has held up through the first half of 2022, this year may be a tale of two halves if demand slows in the second half of the year for discretionary businesses,” said Ron Kahn, a managing director at Chicago-based Lincoln, in a statement.

In the second half of the year, “private company growth hinges on consumers’ willingness and ability to spend and private companies’ efforts to, mitigate inflationary pressures impacting margins,” he added.

Meanwhile, the Lincoln Private Market Index, a measurement of private company enterprises values (EV), declined 0.5% in the quarter - it’s first drop since the beginning of the pandemic. In the previous quarter, the gauge rose 1.7% as private companies were able to shrug off the volatility hitting public markets, but the headwinds have appeared to have caught up to private companies.

Previously stable earnings were able to stave off declines in EV multiples, but Lincoln’s latest report shows a drop to 10.8 times in the recent quarter, down from 11.1 times in the quarter prior. 

“As we have historically observed, portfolio companies in the private markets are not insulated from trends in the public markets and recessionary fears.” said Steve Kaplan, a professor of entrepreneurship and finance at the University of Chicago and an adviser to Lincoln’s index.  

Lincoln’s Senior Debt Index, a measurement of the fair-market values of loans for private companies, declined for a second consecutive quarter to 97% from 98% reported in the first, while default rates crept up to 3% in the second quarter, from 2.5%. Kahn expects the default rate to rise for the rest of the year. 

“Although private credit default rates remain low and interest coverage ratios remain in line with levels observed over the past year, that could quickly reverse course as private companies face a storm of rising rates and recessionary fears,” said Kahn.

 

Edited February 16, 2023 by thepupil

[rkbabang]

On 2/15/2023 at 10:42 AM, thepupil said:

 

I think many people care about indices because it's their only option. My wife and I save  $67K/year through tax advantaged vehicles. we save more on top of that, but it's a material amount of money for us and our 401k providers only allow various indices/mutual funds. Unless we quit our jobs we have to buy something with that, so having some opinion on the relative merits of the performance of various asset classes is of some use to me. 

 

for me right now I wonder whther I should keep buying bond index, switch to long term bonds, or use it to add international / non USD exposure. my portfolio's always gonna be US stock/RE heavy. for now I think bonds are a better diversifier than non US stocks. 

 

That sucks, try to convince your company to use Fidelity for your 401K.  My company uses Fidelity and it has the normal selection of funds or you can transfer the money into what they call 401K Brokerage Link and invest it into anything that you could in an IRA, even options (buy calls/puts, write covered calls and cash backed puts).

 

[Castanza]

1 hour ago, rkbabang said:

 

That sucks, try to convince your company to use Fidelity for your 401K.  My company uses Fidelity and it has the normal selection of funds or you can transfer the money into what they call 401K Brokerage Link and invest it into anything that you could in an IRA, even options (buy calls/puts, write covered calls and cash backed puts).

 

 

Hmm had no clue this was a thing. My company uses Fidelity. Will have to check this out. Did Christmas just come early?!

 

Edit: Not offered for me....damn 

Edited February 16, 2023 by Castanza

[maplevalue]

1 hour ago, Viking said:

In Canada anyone with a mortgage or line of credit is now (or will be shortly) paying much, much more in interest expense. $100/month more doesn’t matter. $1,000/month more does matter. $2,000/month matters even more. This is an after-tax increase in expenses. At the same time food costs are way up. Insurance costs are way up. Flight costs are way up. Vehicle costs are way up (if you can even find one). Etc, etc. Wages? Up a little.
 

What does it all mean for an investor? Not sure. It will likely take years to fully play out. But given the magnitude of the impact, there will be big winners and losers. And that is the fun part about investing… skate to where the puck is going… 

 

On the point of it "likely take years to fully play out", you are very right on that from a Canadian perspective since 75% of variable rate homeowners payments are fixed (i.e. payment same, interest/principal split changes, or amortization extended; https://www.bankofcanada.ca/2022/11/staff-analytical-notes-2022-19/). It just delays the pain, but one day these borrowers will have to pay!

[rkbabang]

55 minutes ago, Castanza said:

 

Hmm had no clue this was a thing. My company uses Fidelity. Will have to check this out. Did Christmas just come early?!

 

Edit: Not offered for me....damn 

Probably disabled by your company for your protection.  

 

[Spekulatius]

1 hour ago, rkbabang said:

Probably disabled by your company for your protection.  

 

Most plans don't have a brokerage window due to compliance concerns (the concern is that participants may blow up their account and then sue the sponsor).

[Santayana]

If you're in the industry, it's not uncommon to have trading restrictions on all of your accounts.

[Minseok]

18 hours ago, maplevalue said:

 

On the point of it "likely take years to fully play out", you are very right on that from a Canadian perspective since 75% of variable rate homeowners payments are fixed (i.e. payment same, interest/principal split changes, or amortization extended; https://www.bankofcanada.ca/2022/11/staff-analytical-notes-2022-19/). It just delays the pain, but one day these borrowers will have to pay!

 

That day is already here. Banks are increasing payment on variable rate mortgages without the consent of home owners when the trigger rate is hit. I voluntarily increased my payment at every rate hike for a total of $1250/month but one of my colleagues has had his bank forcebly increase payment by a total of $800/month through the hiking period. This is from a tier 1 bank. 

Edited February 17, 2023 by Minseok

[Spekulatius]

2 minutes ago, Minseok said:

 

That day is already here. Banks are increasing payment on variable rate mortgages without the consent of home owners when the trigger rate is hit. I voluntarily increased my payment at every rate hike for a total of $1250/month but one of my colleagues has had his bank forcebly increase payment by a total of $800/month through the hiking period. This is from a tier 1 bank. 

I am in the US and have a fixed mortgage, but my cost of homeownership still goes up by 4-5%. The reason is power (up ~25%) and NG is getting more expensive as well as real estate taxes keep creeping up.

 

The inflation looks like whack a mole to me. OK, fuel is down, used cars are down yoY, but now used car prices seem to rise again. Energy (except fuel) is getting way more expensive.  So you have these rolling inflation waves hitting you at different times but overall it looks like there is some persistency there. Or does anyone really thinks that rents for example will start to shrink? Rents tend to be sticky.

 

I see this at work too - the company I work for still tries to push down price increases - roughly 5-7% now. There is more pushback than last year. Some of the crazy input cost spikes for some materials are gone, but there is just a wave of overall input price increases as far as I can tell.

 

All those price increases used to be 0-2% ballpark until about 2020 when hell broke loose.

[thepupil]

 

yea same.

 

we use nuclear and natty for power/heating/etc so energy costs haven't been bad at all. but other stuff...a

 

since i bought in 2019:

 

property taxes:      +20% 

insurance:              +50% (but it was stupid low before)

other maint            +30-50%+ (annual mulch, gutter cleaning, that type of stuff

 

as a real estate investor if rents did ever go down because of s/d but the inflated opex stayed the same...NOI would get hurt a lot more obviously. 

Edited February 17, 2023 by thepupil

[Gregmal]

A lot of the real estate stuff and underpinning inflation is all complicated by the fact that there’s varying degree of correlation and it’s not all good or bad but a mixture that largely bets itself out. You aren’t poorer because property taxes went up; your property taxes went up because most likely, your home value went up. Costs of new water heaters and copper pipes goes up, but again, the cost to build did, if you own the build, it’s more negligible than you thought. Insurance goes up, because your home would cost more to replace, etc. That’s what I think gets missed a lot when people only look at say, an NOI or a fluctuating stock price. You aren’t getting as poor/rich as you think; it’s largely, by it’s very nature, just a robustly decent inflation hedge. 

[mattee2264]

Buffett always hedges his opinions on market levels by saying it depends on interest rates and interest rates are like gravity on financial assets. But we don't really seem to be seeing that to a large degree.

 

30 year US treasuries have increased from 2% at the end of 2021 to almost 4% today and could well head higher than 5% as most of the so-called disinflation just reflects energy prices coming down because the US are draining their SPR. 

 

The SPY peak was around 4800. That represents around 23x TTM earnings of $210 a share. To justify that you'd have to believe that those earnings were sustainable and interest rates would stay low and the 2% equity risk premium while below the historical average could be justified because of future growth potential or continued faith in the Fed put. 

 

Currently the SPY has fallen only 15% to 4100. Even if you use 2021 earnings that is still almost 20x earnings. This seems consistent with the idea that markets are pricing in an immaculate disinflation which will allow a Fed pivot so that interest rates fall to a 2% level which can be used to justify 20+ PE ratios AND that there will be a V shaped recovery of earnings to 2021 levels or higher within the next year or two. 

 

[thepupil]

Just now, mattee2264 said:

Buffett always hedges his opinions on market levels by saying it depends on interest rates and interest rates are like gravity on financial assets. But we don't really seem to be seeing that to a large degree.

 

30 year US treasuries have increased from 2% at the end of 2021 to almost 4% today and could well head higher than 5% as most of the so-called disinflation just reflects energy prices coming down because the US are draining their SPR. 

 

The SPY peak was around 4800. That represents around 23x TTM earnings of $210 a share. To justify that you'd have to believe that those earnings were sustainable and interest rates would stay low and the 2% equity risk premium while below the historical average could be justified because of future growth potential or continued faith in the Fed put. 

 

Currently the SPY has fallen only 15% to 4100. Even if you use 2021 earnings that is still almost 20x earnings. This seems consistent with the idea that markets are pricing in an immaculate disinflation which will allow a Fed pivot so that interest rates fall to a 2% level which can be used to justify 20+ PE ratios AND that there will be a V shaped recovery of earnings to 2021 levels or higher within the next year or two. 

 

 

 I'll put my bull hat on here. I don't think markets ever really fully priced in 2% rates / negative real rates, so It's not entirely surprising that they haven't come down more than an academic duration measure might suggest given the move in the 10-30 year treasuries.

 

I'm guilty of this too, but a gentle reminder that the equity risk premium is Total Expected Return on Stock - Expected Return on Bond, though some folks (includng me) will define as earnings yield - bond yield. Both of these remain positive, but assuming LT growth in earnings, the one with total return is obviously much more positive (as there's little differential b/w earnings yields and bond yields at this time). 

 

 

 

 

 

[TwoCitiesCapital]

46 minutes ago, thepupil said:

 

 I'll put my bull hat on here. I don't think markets ever really fully priced in 2% rates / negative real rates, so It's not entirely surprising that they haven't come down more than an academic duration measure might suggest given the move in the 10-30 year treasuries.

 

 

 

While I understand the theory of WHY interest rates matter, and how they play through the discounting mechanism, historically the correlation between interest rates and movements in equities or multiples in equities has been spurious. 

 

Even directionally there have been extended periods of time where bonds were positively correlated (consistent with the academic theory) and extended periods of time where they were negatively correlated (inconsistent with the academic theory). 

 

What has WAY more explanatory power is the inflation rate. When inflation is stable at ~0-4%, you get high equity multiples. As inflation gets above, or below, that threshold you get dramatic contractions on those multiples.

 

This is consistent with what we've witnessed in 2022. The contraction started because inflation was 6% and heading to 9%. It's paused/reversed some as inflation came back done from 9 to 6% and markets are hopeful the Fed can thread the needle and get it back to 0-4%. 

 

It's more probable, IMO, that the multiple contraction continues as I expect inflation to be unstable and bounce around quite a bit as opposed to the nice, consistent 1-2% we saw most years from 2009-2019. 

 

 

[Gregmal]

13 minutes ago, TwoCitiesCapital said:

It's more probable, IMO, that the multiple contraction continues as I expect inflation to be unstable and bounce around quite a bit as opposed to the nice, consistent 1-2% we saw most years from 2009-2019. 

 

 

I dont think we see 1-2% sustained barring some sort of massive and unlikely reset. But if the range of outcomes is 0-4%, 4-6%, and 6%+....I certainly think that overall we're treading in the middle right now, and that we are probably closer(hence valuations) to pricing into the 0-4% inflation range, but at the same time, going all out on an aggressive short or cash hoard approach seems to be banking on a hard swing into the 6%+ range. So in a roundabout way, summing it all up, I think you need to be picking single stocks wisely and with a longer term fundamental based approach, because "the indexes" or whatever just seem like they dont have a predictable catalyst to go up/down in a way that makes wagering on that worthwhile. Kuppys blog again on "I just dont know" seems spot on. The clear bubble stuff is gone. Theres some stuff thats cheap but not nearly as much as a couple Qs ago. So otherwise, its like what are we playing for? 

[mattee2264]

Agree if you are picking your spots it matters less. Value stocks for example often do quite well during inflationary periods. But of course the big winners this bull market that still dominate the indices are the growth stocks which are quite sensitive to interest rates and inflation and have seen a pretty big rebound because markets seem to be quite confident about an immaculate disinflation and a Fed pivot.

 

And as a lot of the long bull market has been driven by multiple expansion based on low interest rates and the idea that TINA to equities then a moderation of market multiples and a re-allocation towards bonds doesn't feel like a supportive environment for equities especially if earnings fail to hold up.

 

And interestingly it is a similar dynamic. At first people were reluctant to price up equities even though interest rates were near zero post GFC because they thought zero interest rates were temporary. Then they got comfortable with the idea that interest rates would stay low and the Fed would cut at the first sign of trouble and multiples drifted above 20. Now even though interest rates are a lot higher people assume it is just transitory and they will fall back down once inflation is tamed and are still pricing based on a low interest rate environment. Perhaps again it will take time before people start to believe that higher (but still quite moderate by historical standards) interest rates are here to stay and adjust multiples accordingly. 

 

 

[TwoCitiesCapital]

2 hours ago, SHDL said:

 

My own take is that stocks aren't down that much because real rates haven't really gone up that much. Nominal rates are up, yes, but inflation is up too so it is not clear if bonds are all that attractive vs equities. At least personally I look at these ~4% long term bond yields and say to myself okay great but I think inflation is going to be just about has high so my real return is going to be really low and so I just hold on to my stocks.

 

So I think for the market as a whole to go down meaningfully valuation alone won't do it - we need either the economy to deteriorate meaningfully or have the Fed jack up rates much much higher. Those things could happen of course but at the moment I'm not quite feeling it.

 

Our of curiosity, how are you measuring meaningful deterioration? 

[Gregmal]

29 minutes ago, SHDL said:

I can't really tell if we are just cooling down a little coming out of this strange boom period or if things are about to get much worse. 

This is a thing that over time Ive desensitized myself to. For the past decade plus, every single year in memory we've had "signs" of impending doom or downright disaster and plenty of folks claiming theyre just around the corner. Every single one of them. Same goes with the "valuation" argument. In hind site everyone knows just how obvious this fed and liquidity driven, decade long boom was. At the time? LOL Not so much. So my default answer is to just invest wisely and buy things that are durable and desirable. 

Edited February 17, 2023 by Gregmal

[mattee2264]

For the past decade the Fed has been bailing investors out at the first sign of trouble and interest rates have been persistently low and a low growth low inflation environment has been very favourable to secular growth companies who've been able to juice returns by buying back lots of shares. And they even admitted that they were deliberately suppressing interest rates to encourage investors to chase returns and bid up risk assets such as equities to generate positive wealth effects. We had a soft landing in 2015 and 2018. In 2020 unprecedented monetary and fiscal stimulus saved the day. And somehow even with successive rounds of QE and persistently low interest rates inflation remained low. Until it didn't. 

 

 So ignoring the noise and buying the dips was the winning strategy and the higher your equity allocation the better the results. So understandable that markets are somewhat complacent and assuming there will be an immaculate disinflation with a soft landing and even if something does break the Fed will go back to QE and all will be well. 

 

But who knows perhaps a decade from now it will seem obvious that the Fed withdrawing liquidity through QT and taking interest rates from zero to 5% or higher and keeping them there longer than the market initially expected would result in a lost decade with negative real returns. 

 

 

[thepupil]

 

 

some more credit bear porn. Looks like about 30% of B- rates leveraged loan borrowers are at <1.1x and something like 10% at <0.5x

 

reiterate that “the market” (broad cap weighted indices) has very high credit quality, low leverage, and is very well termed out and that 10+ years of regulations have pushed off this risk off bank b/s’s.
 

Private equity/private credit is where the bodies are buried / will be. 

[changegonnacome]

https://www.marketwatch.com/story/investors-have-pushed-stocks-into-the-death-zone-warns-morgan-stanleys-mike-wilson-dcef3c63

Quote

Back to Wilson, who says the P-to-E ratio is now 18.6, and equity risk premium at 155 basis points, meaning “we are in the thinest air of the entire liquidity-driven secular bull market that began back in 2009.” He says the bear market rally that begin in October from reasonable prices has turned into a speculative frenzy based on a Fed pause/pivot that isnt coming.

 

 

Pretty much my thoughts about where we are right now - when the pause/pivot delusion unwinds it’s gonna be interesting to watch.

Edited February 20, 2023 by changegonnacome

[Gregmal]

Looks like he literally just made up the chart and created “zones”. Also, IIRC, isn’t this the guy who in Q4 had this major “call” for a 20% decline in H1 followed by a huge rally to end the year around 4000? I really can’t believe any of this shit gets taken seriously anymore.